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McKinsey Global Institute

New Horizons:
Multinational Company Investment in Developing Economies

New Horizons:
Multinational Company Investment in
Developing Economies

McKinsey Global Institute


With assistance from our Advisory Committee, including:
Martin Baily, International Institute for Economics
Richard Cooper, Harvard University
Dani Rodrik, Harvard University

San Francisco
October 2003

This report is copyrighted by McKinsey & Company, Inc.; no part of it may be


circulated, quoted, or reproduced for distribution without prior written
approval from McKinsey & Company, Inc.

McKinsey Global Institute


The McKinsey Global Institute (MGI) was established in 1990 as an
independent research group within McKinsey & Company, Inc., to conduct
original research on important global issues. Its primary purpose is to
develop insights into global economic issues and reach a better
understanding of the workings of the global economy for the benefit of
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From time to time the institute issues public reports. These reports are
issued at the discretion of MGI's director and its McKinsey Advisory Board
when they conclude that the institute's international perspective and its
ability to access McKinsey's knowledge of industry economics enable it to
provide a valuable fact base to policy debates. The McKinsey Advisory
Board is made up of McKinsey partners from Europe, the Pacific Basin,
and the Americas.
The institute's staff members are drawn primarily from McKinsey's
consultants. They serve 6- to 12-month assignments and then return to
client work. MGI also commissions leading academics to participate in its
research. The institute's director is Diana Farrell, a McKinsey partner.
MGI has locations in Washington, D.C., and San Francisco, California.

Preface
This report is the product of a year-long project by the McKinsey Global Institute,
working in collaboration with our McKinsey partners in multiple office and industry
practices around the world. The inquiry spanned five sectors, including auto,
consumer electronics, retail, retail banking, and information technology/business
process offshoring (IT/BPO), and four developing economies Brazil, Mexico,
China and India. We sought to shed light on the oft-debated question of who
benefits from multinational company investment in the developing world and how.
The release of this report is part of the fulfillment of MGI's mission to help global
leaders: 1) understand the forces transforming the global economy; 2) improve
the performance of their corporations; and 3) work for better national and
international policies.
The fully dedicated project team consisted primarily of McKinsey Global Institute
Fellows, top-performing consultants who rotate into MGI typically for a year and
work on critical pieces of the project. Additional consultants from relevant local
offices joined the team for shorter time periods, typically 2 to 6 months, working
closely with the Fellows.
Jaana Remes, an Engagement Manager from the San Francisco office, joined as
a special MGI Fellow, led the project during the critical stages of cross-country and
cross-sector comparisons and synthesis. She contributed particularly to all the
summary and synthesis work and to the retail sector cases. The team worked
closely and all the individuals contributed to multiple portions of the effort, but
each had a particular contribution that could not have been possible without
them. In alphabetical order, with their primary areas of contribution, the team
included: Vivek Agrawal, Fellow from the San Francisco office (IT/BPO in India,
auto sector in India, overall summary and synthesis), Nelly Aguilera from the
Mexico office (retail in Mexico), Angelique Augereau, Fellow in the San Francisco
office (auto in Brazil and retail in Brazil and Mexico), Dino Asvaintra from the
Shanghai office (consumer electronics in China), Vivek Bansal from the Business
Technology Office in London (IT/BPO in India), Dan Devroye, Fellow from the Miami
office (auto in Brazil and Mexico), Maggie Durant, Fellow from the Chicago office
(retail in Brazil and Mexico), Antonio Farini from the So Paulo office (retail,
consumer electronics and auto in Brazil), Thomas-Anton Heinzl, Fellow from the
Zurich office (overall project management), Lan Kang from the Shanghai office
(auto in China), Ashish Kotecha from the San Francisco office (auto in India),
Martha Laboissiere from the So Paulo office (retail banking in Brazil), Enrique
Lopez from the Mexico City office (food retail in Mexico), Maria McClay, Fellow
from the New York office (global industry restructuring and company implications,
overall summary and synthesis, consumer electronics and auto, all countries),
Jaeson Rosenfeld, Fellow from the Boston office (consumer electronics in China,
Mexico, Brazil and India; auto in China), Julio Rodriguez from the Mexico office
(consumer electronics in Mexico), Heiner Schulz, Fellow from the London office
(retail banking in Mexico and Brazil, policy implications, overall summary and
synthesis). Moreover, Tim Beacom, our dedicated research and information
specialist, Jennifer Larsen, the MGI Practice Administrator, and Terry Gatto, our
Executive Assistant, supported the effort throughout.

ii

iii

This project was conducted under my direction, working closely with several
partners and colleagues around the world, especially Vincent Palmade also from
the McKinsey Global Institute. In the host countries studied, Heinz-Peter Elstrodt
from Brazil, Gordon Orr from China, Noshir Kaka and Ranjit Pandit from India, as
well as Antonio Purn and Rodrigo Rubio from Mexico held the project flag, gave
generously of their time and knowledge, and made it possible for us to make this
bold effort. We also benefited from the input of many of our industry leaders and
experts in each of the sectors studied. Given the importance of the auto sector
to the topic at hand, we were particularly fortunate to have Glenn Mercer, an
expert partner in the auto practice, play a very active role on the project. As
always, the findings and conclusions draw from the unique worldwide perspectives
and knowledge that our partners and consultants bring to bear on the industries
and countries researched in our projects. Their knowledge is a product of
intensive client work and deep investment in understanding the structure,
dynamics, and performance of industries to support our client work.
Over the course of the entire project, we benefited beyond measure from the
extensive and detailed input received from our Academic Advisory Board
members. While building upon the extensive methodologies developed by the
McKinsey Global Institute over the past decade, this project tackled whole new
approaches and issues as well. We are heavily indebted to our advisors for their
excellent contributions in developing our approach and synthesizing our
conclusions. The Board included: Richard Cooper of the Department of
Economics at Harvard University, Dani Rodrik at the Kennedy School of
Government at Harvard University, and Martin Baily Senior Fellow at the Institute
for International Economics. Beyond his participation in the Advisory Board,
Martin Baily is a Senior Advisor to the McKinsey Global Institute and played a
principal advisory role with the team from the inception of the project.
Before concluding, I would like to emphasize that this work is independent and
has not been commissioned or sponsored in any way by any business,
government, or other institution.
Diana Farrell
Director of the McKinsey Global Institute
October 2003

iv

Additional Acknowledgements
Beyond the project directors already mentioned in the preface, we would
also like to acknowledge explicitly some of our colleagues who contributed
specifically their industry and local market insights and knowledge and
provided us with access to executives and experts around the world.
McKinsey & Company's unparalleled network is an essential component
of any McKinsey Global Institute effort.
Brazil
Eduardo Andrade Filho, Jos Augusto Leal, Franz Bedacht, Nicola Calicchio Neto,
Jorge Fergie, Marcos Fernandes, Marcello Ferreira, Ernesto Flores-Roux, Marcus
Frank, Fernando Freitas, Alexandre Gouvea, Cyril Grislain, Bill Jones, Ari Kertesz,
Fernando Lunardini, Heitor Martins, Stefan Matzinger, Eric Monteiro, Klaus Mund,
Rogerio Nogueira, Frederico Olivera, A.C. Reuter-Domenech, Nathalie Tessier,
Helcio Tokeshi, Andrea Waslander, Aleksander Wieniewicz.

China
Stefan Albrecht, David Chu, Paul Gao, George Geh, Tony Perkins, Richard Zhang.

India
Mayank Bansal, VT Bhardwaj, Maneesh Chhabra, Deepak Goyal, Brett Grehan,
Kuldeep Jain, Manish Kejriwal, Shailesh Kekre, Deepak Khandelwal, Neelesh
Kumar Singhal, Anil Kumar, Gautam Kumra, Rajiv Lochan, Ramesh
Mangaleswaran, Shirish Sankhe, Sunish Sharma, Pramath Sinha, Sanjiv Somani,
Brian Thede, Paresh Vaish, Ramesh Venkataraman, Rahul Verma, Sanoke
Viswanathan, Alkesh Wadhwani.

Mexico
We also want to recognize the contribution of the many consultants of the Mexico
Office who collaborated in this effort under the coordination of Antonio Purn and
Rodrigo Rubio.

Contents
Executive Summary
Introduction
Part I
Multinational Company Investment: Impact on Developing Economies
Policy Implications
Part II
Impact on Global Industry Restructuring
Implications for Companies
Part III
Auto Sector Cases
Preface to the Auto Sector Cases
Auto Sector Synthesis
Brazil Auto Sector Summary
Mexico Auto Sector Summary
China Auto Sector Summary
India Auto Sector Summary
Consumer Electronics Sector Cases
Preface to the Consumer Electronics Sector Cases
Consumer Electronics Sector Synthesis
Brazil Consumer Electronics Summary
Mexico Consumer Electronics Summary
China Consumer Electronics Summary
India Consumer Electronics Summary
Food Retail Sector Cases
Preface to the Food Retail Sector Cases
Food Retail Sector Synthesis
Brazil Food Retail Summary
Mexico Food Retail Summary
Retail Banking Cases
Preface to the Retail Banking Cases
Retail Banking Sector Synthesis
Brazil Retail Banking Case Summary
Mexico Retail Banking Case Summary
Information Technology/Business Process Offshoring Case
Preface to the IT/BPO Case
India IT/BPO Case Summary
Methodological Appendix

Executive Summary
Who benefits from multinational company activity in the developing world, and
how? Few topics are more intensely debated or generate more contrasting
emotions than the merits and costs of global economic integration. And few topics
are more in need of a robust set of facts on which to base assessments. To
provide insight, the McKinsey Global Institute launched an in-depth inquiry into
multinational company investment in developing countries. A key finding is that
the overall economic impact of multinational investment on developing economies
has been overwhelmingly positive despite the persistence of host-country policies
that can lead to negative, unintended consequences. Moreover, companies have
only started to capture the large cost savings and revenue gains possible from
operating in these markets. Multinational company investment in the developing
world opens up new horizons for economic development and for company
strategy.
For this study, MGI developed a set of case studies focusing on five sectors:
automotive, consumer electronics, retail, retail banking, and information
technology/business process offshoring in four major developing economies:
China, India, Brazil and Mexico. These case studies shed new light on two sets
of related questions:
What impact has multinational comany investment had on the economies of
the developing world? What are meaningful implications for governments and
policymakers?
How has multinational company investment in the developing world impacted
industry structure and competition globally? What are the implications for
companies making decisions about global sourcing, investments and
expansion?
MULTINATIONAL COMPANY INVESTMENT IMPROVES LIVING STANDARDS IN
DEVELOPING ECONOMIES
1) Most economies clearly benefit. Through the application of capital, technology
and a range of skills, multinational companies' overseas investments have created
positive economic value in host countries, across different industries and within
different policy regimes. In 13 out of 14 case studies, we found the impact overall
to be positive or very positive (Exhibit 1).
2) Improved standards of living and muted impact on employment. The single
biggest impact of multinational company investment in developing economies is
the improvement in the standards of living of the country's population, with
consumers directly benefitting from lower prices, higher-quality goods and more
choice. Improved productivity and output in the sector and its suppliers indirectly
contributed to increasing national income. And despite often-cited worries, the
impact on employment was either neutral or positive in two-thirds of the cases.
In China, since 1995, global auto companies have driven down prices by
31 percent, while improving the quality and selection of cars in the market. Both
labor productivity and output in the sector have increased by at least 30 percent
annually and employment has increased moderately over the same period.

3) Impact on host countries differs depending on whether investment is motivated


by search for lower-cost locations or for new markets. Investment by companies
seeking lower wage costs consistently improved sector productivity, output,
employment, and standards of living in the host countries, all without much
downside. For example, companies in the information technology/business
process offshoring sector have created a new, rapidly growing industry in India that
already employs nearly half a million people. Similarly, the activities of companies
seeking to expand their market in the host country also had a generally positive
economic impact. In these cases, however, the benefits often came at a cost to
incumbent, less productive companies, and the impact on employment was
mixed. Wal-Mart's entry into the Mexican food retail market has driven down prices
to consumers, but also driven down average margins in the industry.
4) The banking sector is the exception. While foreign investment in the banking
sector was important to sector capitalization and contributed to productivity, it
failed to have a clear positive impact on consumers or on competition.
INVESTMENT POLICIES MOSTLY INEFFECTIVE BUT COSTLY
1) Popular incentives to foreign investments are not the primary drivers of
multinational company investment and instead have negative and unintended
consequences. Without materially affecting the volume of investment in most
cases, popular incentives such as tax holidays, subsidized financing, or free land
serve only to detract value from those investments that would likely be made in
any case. Many of these policies result in direct fiscal and administrative costs,
as well as indirect costs, particularly reduced productivity. For example,
government incentives in Brazil's automotive industry contributed to
overinvestment and thus low capacity utilization, which reduced productivity
performance. Similarly, import barriers and trade-related investment measures
such as local content or joint venture requirements did not have clear positive
impact, but did limit competition, and protect subscale operations, thereby
dampening productivity performance. In the consumer electronics sector in India,
high import tariffs limited competition and kept prices higher, which led to
significantly lower consumption and output in the sector relative to China. In most
cases, these policies did not achieve their objectives and they typically incurred
significant costs.
2) Foundations for economic development are critical. Our case evidence
suggests that the most value from foreign direct investments can be achieved if
policy strengthens the foundations of economic development, through, for
example, ensuring macroeconomic stability; promoting a competitive
environment; evenly enforcing laws, taxes, and other regulations, and building a
strong physical and legal infrastructure. In the Brazilian food retail sector, for
example, we found that discriminatory and inconsistent tax collection in the sector
provided strong protection to underproductive operations and slowed the
transition to higher productivity formats. By contrast, regulatory reform that
ushered in a reliable power and telecommunications infrastructure in India was an

important precondition to the rapid development of the information


technology/business process offshoring sector in the country.
3) Corruption is not a determining factor. Notably, while we did not explore the
issue explicitly or in-depth, we did not find that corruption played an important role
in reducing the value from investments made or explaining differences in
economic outcomes.
LARGE VALUE POTENTIAL FROM NEW HORIZONS OF INDUSTRY
RESTRUCTURING
1) New horizons for large cost savings and revenue generation are opening up.
The integration of developing economies into global sectors sets the stage for
whole new sets of activities beyond expanding markets and seeking low-cost
facilities. Instead of simply locating full production across the value chain in
lower-cost regions, companies can disaggregate individual steps of the value
chain and locate each step to the lowest-cost location. And rather than simply
replicating the production process within each step, companies can capture
further savings by substituting lower-cost labor for capital. These two steps can
reduce costs by 50 percent, which in turn allows new market entry at significantly
lower price points in old and new markets alike.
2) Most companies have only scratched the surface of the opportunity.
Multinational companies have been well positioned to transfer their competitive
products and processes, but less equipped to tailor them appropriately to local
conditions. Strong local players have been well positioned to understand local
market conditions but often lack capital, product or process technologies. Until
recently, the interplay of industry characteristics, legal or regulatory restrictions,
and organizational limitations has acted as a brake on industry restructuring.
However, as a result of greater competition, regulatory liberalization and new
technologies, many of these seemingly immutable characteristics are now
undergoing major change. These changes are opening new possibilities, making
a greater degree of specialization likely. For companies that capitalize on these
changes, the opportunities are large.
HIGHER STAKES, HIGHER PERFORMANCE STANDARDS
1) The stakes are high. The global auto sector, for example, could create over
$150 billion in cost savings and another $170 billion in revenue. Together, these
opportunities represent 27 percent of the $1.2 trillion global auto industry. Our
sector findings suggest that there are very large opportunities for companies to
create value by taking full advantage of falling barriers in regulation, transportation
cost, communications costs, and infrastructure.
This implies far more than
lowest-cost sourcing. It involves rethinking a firm's entire business processes to
optimize production or service delivery.

2) Aggressive companies will set radically new performance standards. They will
not accept the status quo, but instead push down the barriers or operate around
them. Incremental performance mandates will be increasingly inappropriate as
bolder targets come within reach. Already, a few companies in consumer
electronics, auto, and the information technology/business process offshoring
sector are leading the charge. For followers, change will be a matter of survival.
3) Success requires good strategy and execution against new tradeoffs in new
market environments. Finding the optimal location and choice of capital and labor
inputs in each production step, effectively balancing a company's global
capabilities with local knowledge of markets, and shifting to more nuanced global
management are just some of the new challenges facing companies.
ABOUT THE STUDY
Like all McKinsey Global Institute initiatives, this study merged detailed, companylevel insights with macroeconomic data to produce a unique synthesis and new
perspectives. We conducted detailed analysis and extensive interviews with client
executives, external experts, and McKinsey experts over the course of more than
a year. Nearly 20 fully dedicated team members from around the world invested
more than 20,000 hours to produce 14 detailed case studies that form the basis
of our more broadly stated conclusions (Exhibit 2). In this effort we benefited from
the advice of a team of eminent economists, including Martin Baily, Dick Cooper
and Dani Rodrik.

Exhibit 1

FDI TYPOLOGY AND OVERALL FDI IMPACT ASSESSMENT

Very
positive

Positive
Overall
FDI
impact

Consumer
electronics, China

Auto, India

Auto, Mexico
Consumer
electronics, Mexico
Consumer
electronics, China
BPO

Food retail, Mexico


Food retail, Brazil
Retail banking,
Mexico

Auto, China
Consumer
electronics, Brazil
Consumer
electronics, India
Auto, Brazil

IT
Efficiency seeking
FDI is
overwhelmingly
positive
For market seeking,
impact ranges from
neutral to very
positive

Retail banking,
Brazil
Neutral

Negative

Pure market
seeking

Tariff jumping

Efficiency seeking

Motive for entry

Source: McKinsey Global Institute

Exhibit 2

Auto

++ Very positive

Overall positive impact

FDI IMPACT IN HOST COUNTRY

Negative

Mixed

+ Positive

Very negative

Negative

0 Neutral

[ ]

Estimate

Consumer electronics

Food retail

Retail banking
Brazil

Brazil

Mexico

China

India

Brazil

Mexico

China

India

Brazil

Mexico

Level of FDI
relative to sector*
Economic impact
Sector
productivity
Sector output

52%

6.5%

33%

n/a

30%

15%

29%

35%

4.2%

2.4%

n/a

6.9%

++

++

[+]

[+]

0/+

[+]

[++]

++

++

++

++

[0]

[+]

[+]

[+]

[++]

Sector

[]

++

[0]

[]

[+]

[++]

Suppliers

++

[0]

++

[0]

[0]

[+]

n/a

n/a

Impact on
competitive
intensity

++

[+]

++

[+]

[+]

Mexico IT

BPO
2.2%

employment

Distributional impact

Companies
Companies
with FDI
Companies
without FDI

[+]

++

[+/]

[+]

+/

+/

+/

++/

++

[0]

[0]

n/a

n/a

[0/ ]

0/

[0/]

[]

[++]

0
+

+
++

+
+

0
+

[0]
[0]

++
[0]

+
[0]

[+]
[0]

0
[0]

[]
[0]

[0]

[+]
[+]

[++]
[++]

Reduced prices

++

[0]

[0]

++

n/a

n/a

++

[+]

[+]

[+]

[0/+]

[+]

0
0

Selection

n/a

n/a

Taxes/other

++

[0]

[0]

[+]

[0]

++

[0]

[0]

[+]

Overall assessment

++

++

++

++

++

Employees
Level
Wages

Consumers

Government

* Average annual FDI/sector value added in last year of focus period

Introduction
THE TRANSITION TO A GLOBAL ECONOMY
A surge in multinational company activity in the developing world has opened a
new chapter in globalization. As companies in search of lower costs and new
markets step-up their direct investments in developing countries, economies are
becoming ever more interdependent and the pace of economic change is
accelerating. Once marginal to most firms' core business, operations in
developing countries are becoming essential to their competitiveness and growth.
Few topics are more intensely debated or create more contrasting emotions than
the merits and costs of global economic integration. And few are more in need
of a robust set of facts on which to base assessments.1
In light of these developments, the McKinsey Global Institute launched an indepth inquiry into the cross-border activities of multinational companies. We
focused on five sectors automotive, consumer electronics, retail, retail banking
and information technology/business process offshoring in four major developing
economies China, India, Brazil, and Mexico. These sector case studies shed
light on two sets of related questions:2
What impact has multinational company activity had on the economies of the
developing world? What are meaningful implications for governments and
policymakers?
What has been the impact on global industry structure of multinational
company activity in the developing world? What are the implications for
companies making decisions about global sourcing, investments and
expansion?
PROJECT APPROACH
Like all McKinsey Global Institute studies, this study merged detailed, companylevel insights with macroeconomic data to produce a unique synthesis and new
perspectives. Detailed analysis and extensive interviews with client executives,
external experts, and McKinsey experts were conducted over the course of several
months. Eighteen fully dedicated team members from around the world invested
1.

2.

The heated debate about the benefits and costs of globalization has been enriched recently by
a set of surveys of the economic evidence available including, to mention two prominent
ones, CEPRs "Making Sense of Globalization" sponsored by the European Commission (2002),
and Stanley Fisher's "Globalization and Its Challenges" (2003). These have been attempts by
economists, trained to appreciate the benefits of well functioning markets, to take a hard look
at the evidence on issues of poverty and global standards of living and address some of the
challenges raised by critics of globalization. Yet a survey by CEPR of the very extensive
literature on the impact of globalization on growth and poverty reduction concludes that it "is
difficult to be sure whether the poor economic performance of some countries . . . is due to
their having been insufficiently open to the world economy, or whether they lacked the
institutions and capacities . . . that would have enabled them to benefit from the
opportunities."
We have addressed a third question, the impact of offshoring on the U.S. economy, in a
separate article, "Off-Shoring: Is It a Win-Win Game?", available at the McKinsey Global
Institute Web site.

over 20,000 hours to produce 14 detailed case studies that form the basis of our
conclusions, which are more generally applicable (Exhibit 1).
Case study focus
Given the traditional difficulty of isolating the impact of foreign direct investments
(FDI) from all other factors affecting economic development, the case study
approach allows us to take a very detailed look at the specific components of
economic impact and the way the impact comes about. This approach is
especially needed in developing economies. Indeed, in the context of the impact
multinational companies (MNCs) have on industry dynamics, the Organization of
Economic Co-Operation and Development (OECD), stated that "ideally, an analysis
of competitive effects would rely on case studies, but in the past 20 years, no
case studies on MNCs' impact on competition have focused on developing
countries."
One of the benefits of the case study approach is that it allows us to make
distinctions among different kinds of foreign direct investments. We find three
distinctions particularly useful:
Motive of FDI whether MNCs invest in developing countries to gain access to
their domestic markets (market-seeking investments), or to produce goods for
exports (efficiency-seeking investments).
Type of investments made whether they involve new plants or operations
(greenfield investments), transfer of ownership of existing assets (acquisitions),
or investments expanding already existing operations of multinational
companies.
Stage of investment whether MNCs have entered recently with early stage
investments or have been established in a country and their capital outlays can
be considered mature investments, or whether investments in the period were
largely incremental advances on an established asset base in the host country.
Another benefit of the case study approach is that it allows us to complement the
hard economic data by its nature always dated with interviews and
observations which reveal more recent operational changes and current plans.
The combination of these different sources of information helps us understand
how the impact of foreign investments is felt at the microeconomic level.
Sample of large developing economies
We have focused on four of the most important large developing countries
China, India, Brazil, and Mexico. They provide a very good sample for studying the
impact of FDI because each one has gone through some form of liberalization
toward foreign investments in the past 15 years, and has received significant new
FDI inflows since 1995 as a result. The choice of two Latin American and two
Asian countries provide an additional set of contrasts that enrich the analysis.

Exhibit 1

OVERVIEW OF COUNTRIES/SECTORS STUDIED


India

China
9

Mexico

Brazil
9

Auto
Mature FDI
1998-2001

Consumer
electronics

9
Mature FDI
1995-2001

Mature FDI
1993-2003

9
Early FDI
1994-2001

Incremental FDI
1995-2000

Incremental FDI
1994-2000

Mature FDI
1994-2001

Mature FDI
1990-2001

Retail
Mature FDI
1995-2001

Retail
banking

Early FDI
1996-2002

9
IT/BPO*
Early FDI
1998-2002

* Information technology/business process offshoring

Early FDI
1996-2001

9
Early FDI
1996-2002

All the case countries have very large domestic economies, with gross domestic
products ranging from $477 billion in India to $1,159 billion in China (Exhibit 2).
They are at somewhat different stages of economic development, as Brazil and
Mexico have roughly twice the GDP per capita (at PPP) of China and India
(Exhibit 3). And while they have all received significant FDI inflows since 1995,
China has attracted more than $200 billion in investments more than all the
others combined (Exhibit 4).
The four countries had very different macroeconomic environments during our
study periods (Exhibit 5). The 1990s was a period of very rapid growth in China,
with annual GDP growth consistently above 7 percent, making it a very attractive
market for foreign investors. India was also growing throughout the decade at a
more modest rate, while a steady rate of currency devaluation in real terms
reduced the cost of production there relative to the rest of the world. In Brazil and
Mexico, the 1990s were much more volatile. Brazil's hyperinflationary period in
the mid-1990s was followed by deep economic downturns in both 1998 and
2001. Mexico in turn went through a deep devaluation and recession in 1995,
followed by a rapid recovery and a period of slow revaluation of the peso. In all
four countries, the interplay of two variables domestic market growth and
exchange rate determining the cost of domestic production relative to the rest of
the world fundamentally affected the level of foreign investments, as well as the
returns and impact of those investments.
The regulatory and policy contexts for foreign investments were also very different
in the four countries (Exhibit 6). At the starting point in the early 1990s stateowned enterprises played a dominant role in large parts of the Chinese economy,
Brazil had its import substitution policies, there was a highly regulated
environment in India, and in Mexico the policies were being rapidly liberalized in
a process that culminated in NAFTA in 1994. All countries relaxed some
constraints on foreign investors during this time, and provided specific tax holidays
or other incentives to export-oriented foreign investments (Exhibit 7).
Range of different sectors
Our cases cover five industry sectors: automotive, consumer electronics, food
retail, retail banking, and information technology/business process offshoring
(IT/BPO). The mix of both manufacturing and service sectors with very different
characteristics provides a good platform for drawing cross-sector conclusions that
can be generalized more broadly (Exhibit 8). However, we do not include any
natural resource-intensive sectors (e.g., oil and gas), or regulated utilities (e.g.,
telecommunications), since idiosyncratic characteristics make these and other
similar sectors sufficiently different that they would require separate analyses.
Country and company perspectives
We have explicitly taken into account both the country and company perspectives
in our analyses. Company decisions about how much and where to invest and
what kind of production and managerial methods to use are the fundamental

Exhibit 2

CASE COUNTRIES AT A GLANCE 2001


China
Population 1,272 million
GDP
$1,159 billion
(at exchange
rate)

Mexico
Population 99 million

GDP

$618 billion (at


exchange rate)
Agriculture 4% of GDP

Industry

27% of GDP

Services

69% of GDP

Trade

54% of GDP

Agriculture
Industry
Services
Trade

15% of GDP
51% of GDP
34% of GDP
44% of GDP

Brazil

India

Population 172 million


$502 billion (at
GDP

Population 1,032 million


GDP
$477 billion (at

exchange rate)

Agriculture
Industry
Services
Trade

9% of GDP
34% of GDP
57% of GDP
23% of GDP

Agriculture
Industry
Services
Trade

exchange rate)
25% of GDP
27% of GDP
48% of GDP
20% of GDP

Source: WDI 2003

Exhibit 3

COUNTRIES AT DIFFERENT STAGES OF ECONOMIC DEVELOPMENT


2001
Average income
of top 10% of
population
Dollars at PPP

GNP per capita


Dollars at PPP

7,070

Brazil

Mexico

China

India

33,017

8,240

3,950

2,820

Income
distribution
Gini coefficient*

34,278

12,008

9,447

* Measure of income inequality ranging from 0 (perfect equality) to 1 (extreme inequality).


Source: WDI 2003

59.1

51.9

40.3

37.8

Exhibit 4

COUNTRIES WITH DIFFERENT LEVELS OF FDI INFLOWS


Average FDI as
share of GDP
Percent

Cumulative FDI
1995-2000
$ Billions

123

Brazil

Mexico

3.6

2.0

60

209

China

India

3.8

13

0.6

Source: UN

Exhibit 5

DIFFERENT MACROECONOMIC ENVIRONMENTS

GDP
Exchange rate

Mexico

Brazil
GDP growth rates
Percent

Exchange rates
(1990 = 100)

Exchange rates
(1990 = 100)

Crisis in 1998
and 2001

GDP growth rates


Percent

500

12,000,000
4

8,000,000

4,000,000

-3
-6
1990

-8
1990

100

1993

1996

1999

2002

China

100
1992

1994

1996

1998

2000

2002

India

GDP growth rates


Percent

Exchange rates
(1990 = 100)
Sustained
rapid growth

15

200
175

10

GDP growth rates


Percent
Liberalization
10
of market
8

Exchange rates
(1990 = 100)
300
250

150
5
0
1990

300

Crisis in 1995
followed by
rapid recovery

-4

1993

Source: Global insight

1996

1999

2002

200
4

125

100

0
1990

150
100
1993

1996

1999

2002

Exhibit 6

RANGE OF POLICY ENVIRONMENTS


Brazil

Mexico

Historically, government imposed high level of

Overall rapid decline of barriers since the 1990s

tariffs to protect local production

Liberalization phase opening up country for


increased FDI began in the early 1990s

To increase investment in the Amazon, the


government offered special incentives in Manaus
(e.g., income tax exemptions)

Other state governments offered tax breaks in


order to compete with Manaus and attract
investment to their regions creating tax wars,
particularly in the auto sector

China

India

Historically, very high trade barriers (e.g., import

Liberalization phase opening up country for

tariffs, JV requirements) and restrictions to foreign


investments
The government created Special Economic Zones
(SEZs) to encourage greater FDI for export by
offering financial incentives (e.g., national and
local tax breaks and holidays) for foreign
companies
Liberalization increased with the 2001entrance
into the WTO

Source:

that culminated to the signing of NAFTA in 1994


which will remove all tariffs on North American
industrial products traded between Canada,
Mexico, and the US within 10 years
By 1999, 65% of all industrial US exports entered
Mexico tariff free
Trade policies give maquiladoras* special
advantages (e.g., lower tariffs) in exporting to the
US market, the largest importer of Mexican goods

increased FDI began in 1991

Significant incentives offered to IT/BPO


companies in India, including tax holidays, in
order to attract FDI and develop industry
Special Economic Zones (SEZs) with significant
tax breaks and holidays created to increase
investment in select states in India

* Plants that import parts and components from abroad, assemble the inputs into final goods, and then export their output; they are most
active in electronics, auto parts, and the apparel industries
Literature searches; McKinsey Global Institute

Exhibit 7

TARGETED FDI POLICIES AND INCENTIVES


Brazil: Manaus Free Trade Zone

Mexico: Maquiladoras

To increase investment in the Amazon, the government

Maquiladoras are plants that import parts and components

created a Free Trade Zone in Manaus. Select incentives


include:
Income tax exemption for setting up or modernizing
businesses
Subsidized financing from the Amazon Investment Fund
Import tax exemption for sectors Sudam considers
priorities and for consumption within the Free Trade Zone
Export tax exemption for sales to other countries
Exemption from tax on manufactured products (IPI)
Reduction and credit of ICMS (equivalent to a state VAT)
Reduced tariffs on products shipped from Manaus
Exemption from import license fees

China: SEZs

India: Tax holidays

The government created Special Economic Zones (SEZs)

90% of the profits derived by many technology companies

to encourage greater FDI by offering financial incentives for


foreign companies including:
National income tax breaks: If located in Shenzhen,
Zhuhai, Shantou, Xiamen, and Hainan Island,
companies pay 15% rather than 30%
Tax holiday: Production FIEs* operating for more than
10 years get a 2-year tax exemption starting from the
first profit-making year, followed by a 3-year 50% tax
rate reduction
Local income tax: Local authorities can reduce from
3% to 0%

Source:

from abroad, assemble the inputs into final goods, and then
export their output; they are most active in electronics, auto
parts, and the apparel industries
Many are Mexican-owned facilities that deal with
multinationals through arms-length transactions
Initially, trade policies in the Mexico and the US gave
maquiladoras special advantages in exporting to the US
market; companies also benefited from Mexicos low labor
costs
The US is the primary destination for the finished products

* Foreign Investment Enterprise with its head office in China


Literature searches

in India will be deductible from their total income

Any infrastructure undertaking that develops, develops and


operates, or maintains and operates a Special Economic
Zone (SEZS), will be entitled to a tax holiday for 10
consecutive assessment years out of 15 years

Exhibit 8

BROAD RANGE OF SECTORS IN OUR SAMPLE


Remote
digital
service

Hardcore
manufacturing

Auto
assembly

Consumer
electronics

Retail

Retail
banking

IT/BPO

Characteristics
Manufacturing

Services

Industry
High weight/
value ratio
Medium speed
of tech change

Legal/
regulatory

Organizational

High tariffs

Medium weight/value ratio

High speed
of tech change

Low tariffs

Unions play
strong role

Minimal weight/value ratio

Low speed of tech


change

By product
variable tariffs

High regulation

Medium speed
of tech change

Minimal/no tariffs

Unions play minimal role

Exhibit 9

INTERTWINED COMPANY AND COUNTRY PERSPECTIVES

Governments set regulatory and


macroeconomic environment . . .
Import tariffs
Trade policies
Macroeconomic environment
Labor market regulation
Capital market regulation
Tax rates and enforcement

. . . that sets the context for


companies maximizing profits . . .
Revenues = P.Q.
Costs = W.L. + V.K.
Taxes = T
Profits = S

. . . and company decisions


determine sector productivity
through decisions on
How much to invest and where?
What kind of production methods to
use? (e.g., capital/labor trade-off)
How to organize and manage
production? (e.g., role of local
management)

drivers of sector productivity and MNC impact on host countries. We put special
emphasis on understanding the interplay between the policy environment set by
governments and their impact on company behavior and the competitive
environment within the industry and, ultimately, back to sector economic
performance (Exhibit 9).
PART I: IMPACT ON DEVELOPING ECONOMIES AND POLICY IMPLICATIONS
Part I synthesizes our findings on the economic impact of multinational company
investments on developing countries and how the impact radiates across the
different stakeholders within the host country. We also draw overall conclusions
on how multinational companies achieve impact either by introducing operational
changes or changing industry dynamics within the sectors. Based on the case
evidence, we derive implications of economic policy for host countries.
PART II: IMPACT ON GLOBAL INDUSTRY RESTRUCTURING AND
IMPLICATIONS FOR COMPANIES
Part II builds on the case evidence to characterize the patterns of global industry
restructuring as the large developing economies become increasingly integrated
into the global economy. The purpose of the synthesis is both descriptive to add
insight on the patterns of global industry expansion observed today and
prescriptive to help companies identify and capture global opportunities. We
then draw on the pool of company experiences in our cases to derive implications
for companies seeking to capture value from the global opportunities.
PART III: THE FACT BASE OF SECTOR CASE STUDIES
The fundamental fact base for our research is a set of 14 sector-country case
studies that look at MNC investments, measured by FDI, in developing countries
at a microeconomic level, assessing the impact of these investments on sector
performance and different host country constituencies. We then identify the
benefits and costs of FDI to both countries and firms by looking at common
patterns across our industry case studies. We synthesize these findings in
summary assessments of MNC impact on developing countries, and of patterns
of global industry restructuring, and derive implications for both companies and
policymakers (Exhibit 10).
We have organized the case findings into industry summaries, and each summary
includes the following sections:
Preface to each sector includes very brief background on the industry,
characterization of FDI flows in the sector, and any definitions that are needed
for the reader to navigate through the sector-country summaries.

10

Exhibit 10

FINDINGS BASED ON CASE STUDY FACT BASE


1 Fact base of 14 sectorcountry cases in 5
sectors

IT/BPO
Retail banking
Food retail
Consumer
electronics

2 Synthesis of findings across


cases
Impact on
developing economies
Economic impact on
Productivity
Output
Employment
Spillovers
Distribution of impact
Companies
Consumers
Employees
Government

3 Implications

Policy
implications for
governments

Auto
Sector case evidence
Preface
2-4 country cases
Synthesis

Impact on global
industry restructuring
Market entry
Product specialization
Value chain disaggregation
Value chain re-engineering
New market creation

Implications for
companies

11

Sector synthesis provides a brief overview of the global sector as context for
the investments made by multinational companies in our cases, and
synthesizes the findings and explains the variances in FDI impact between the
cases.
Individual sector-country summaries provide the core content of our
research and findings. Each summary starts with an overview of the sector and
FDI inflows during our focus period, explaining the external factors that
influenced the level of foreign investments. At the heart of each analysis is an
assessment of the economic impact of FDI on the host country, measured by
sector output, employment, and productivity, as well as of spillover impact on
supplier employment and productivity. The distribution of economic impact is
measured by assessing the way FDI has affected different stakeholders: MNCs
and domestic companies through impact on profitability; employees through
level of employment and wages; consumers through impact on prices and
product selection/quality; and government through mainly tax impact.3 We
then describe the mechanisms both direct and through changes in industry
dynamics by which FDI achieved impact, as well as the external factors that
influenced FDI impact in each case.4

3.
4.

Our focus is exclusively on national government, not on state governments, which can differ
when states use incentives to compete with one another in attracting foreign investments.
See the appendix on methodology at the end of the document for more details on the
approach.

Multinational company
investment: impact on
developing economies
As developing countries increasingly open up their domestic economies to foreign
players, we assessed the impact of multinational company investment on four
large developing countries (China, India, Brazil, and Mexico). Each of these
countries has gone through some form of liberalization toward foreign direct
investment (FDI) in the past 15 years. We conducted 14 in-depth sector case
studies in five sectors (automotive, consumer electronics, food retail, retail
banking, and information technology/business process offshoring (IT/BPO). The
studies provide a rich fact base for understanding the more detailed pattern of
FDI's impact on host countries and shed light on the process by which FDI has
impact. (Exhibit 1).
FDI INTEGRATING DEVELOPING COUNTRIES INTO THE GLOBAL ECONOMY
Developing countries are being integrated into the global economy through
growing foreign investments (Exhibit 2). While foreign investment during the "first
great globalization era" at the end of the 19th century1 were largely driven by
search for natural resources, companies today are increasingly either seeking
growth by entering developing markets or reducing cost by relocating parts of the
production process to countries with lower labor costs. Two trends have enabled
this evolution: removal of policy barriers limiting foreign trade or investment in
many large economies; and continuing reductions in transactions costs that
enable multinational companies to relocate labor-intensive steps of the
production process across countries in an economic way.
Policy barriers limiting foreign investments have been removed in a
number of large developing economies.
India's selective removal of
prohibitions for FDI entry; Mexico's entry to NAFTA and Brazil's more liberal
policies toward FDI in sectors like consumer electronics are just a few examples
(Exhibit 3).
Transactions costs have declined rapidly as physical transactions costs have
been reduced and telecommunications costs have gone to a fraction of what
they used to be (exhibits 4 and 5). This has enabled companies to
disaggregate production value chains and relocate labor-intensive steps in the
production process to lower labor cost economies increasing
efficiency-seeking FDI.
FIVE HORIZONS OF GLOBAL INDUSTRY RESTRUCTURING
The process of globalization is not uniform across all industries, and there are
large differences in the extent to which developed and developing countries have
been integrated into a single global market. We define five horizons that describe
the different ways in which industry value chain can be restructured across
locations. (Exhibit 6). These horizons are not exclusive of one another, nor
necessarily sequential, and can often be mutually reinforcing.
1.

Among others, Jeffrey Williamson (2002): "Winners and Losers Over Two Centuries of
Globalization". NBER Working Paper #9161.

Exhibit 1

OVERVIEW OF COUNTRIES/SECTORS STUDIED


India

China
9

Mexico

Brazil
9

Auto
Mature FDI
1998-2001

Consumer
electronics

Mature FDI
1993-2003

Incremental FDI
1995-2000

Incremental FDI
1994-2000

Mature FDI
1995-2001

Early FDI
1994-2001

Mature FDI
1994-2001

Mature FDI
1990-2001

9
Retail
Mature FDI
1995-2001

Early FDI
1996-2001

Retail
banking

Early FDI
1996-2002

Early FDI
1996-2002

9
IT/BPO*
Early FDI
1998-2002

* Information technology/business process offshoring

Exhibit 2

FOREIGN CAPITAL IS ONCE AGAIN PLAYING AN INCREASINGLY


IMPORTANT ROLE IN DEVELOPING COUNTRIES
Gross value of foreign capital stock in developing countries
Percent of developing world GDP
32.4

21.7

10.9
8.6
4.4

Total stock in
current prices
$ Billions

1870

1914

1950

1973

1998

4.1

19.2

11.9

172.0

3590.2

Source: The World Economy: A Millennial Perspective, Angus Maddison

Exhibit 3

MANY DEVELOPING COUNTRIES HAVE REMOVED OR LESSENED TRADE


BARRIERS OVER THE LAST 10 YEARS
Brazil

Mexico

In 2000, Brazil decreased most tariff rates

The government entered NAFTA in 1994

by 3%
The government offered large
concessions including land, infrastructure,
tax breaks, and low-interest loans in order
to attract FDI in the auto sector

which will remove all tariffs on North


American industrial products traded
between Canada, Mexico, and the U.S.
within 10 years; by 1999, 65% of all
industrial US exports entered Mexico tariff
free

China

India

The weighted average import tariff

Auto licensing was abolished in 1991


The weighed average import tariff

decreased from 43% in 1991 to 20.1% in


1997
China entered the WTO in 2001
The 40% local content requirements in
the auto sector were removed in 2001
The government funded various
infrastructure projects to attract FDI

decreased over 60% from 87% in 1991 to


20.3% in 1997
In 2001, the government removed auto
import quotas and permitted 100% FDI
investment in the sector

Source: Literature searches

Exhibit 4

TRANSPORTATION COSTS HAVE DECLINED OVER TIME


Revenue per ton mile, cents*

12
120
10
100
8

Air freight

6
4

Rail

2
0
1980

Barge**
1982

1984

1986

1988

1990

1992

1994

* Revenue decreases used as a proxy for price decreases; adjusted for inflation
** For inland waterways shipping (e.g., Mississippi River)
Source: ENO Transportation Foundation

1996

1998

Exhibit 5

TELECOM COSTS HAVE FALLEN DRAMATICALLY, PARTICULARY IN


DEVELOPING COUNTRIES
$ Thousand/year for 2 Mbps fiber leased line, half circuit*
1,000
900
800
700
600
500
400
300
200
100

Philippines
India
Ireland
2001

U.S.**

0
1996

1997

1998

1999

2000

* Cost of international leased line for India; cost of long distance domestic leased line in the U.S.; costs are for
January each year; for India, based on Mumbai or Cochin
** U.S. half circuit data is derived by dividing full circuit data by half
Source: VSNL press releases; literature search; Lynx; Goldman Sachs estimates; McKinsey Global Institute

Exhibit 6

5 MAIN TYPES OF GLOBAL INDUSTRY RESTRUCTURING


Global industry restructuring

5
4
New market
creation

3
2
Value chain
disaggregation

Value chain
reengineering

Product
specialization
Market entry

Companies
enter new
countries in
order to expand
consumer base
(e.g., auto,
retail, and retail
banking) with
similar
production
model to home
market

Source: McKinsey Global Institute

Most components Different


for one specific
product (e.g.,
Sony walkmans)
are produced in
the same
location/region,
with different
regions
specializing in
different products
and trading
finished goods
(e.g., auto)

components of
one product (e.g.,
car engine,
brakes) are
manufactured in
different locations/
regions and are
assembled into
final product
(e.g., consumer
electronics)

After moving
value chain steps
to new location,
processes can be
redesigned
to capture further
efficiencies/cost
savings (e.g,
capital/labor
tradeoffs in
IT/BPO and auto)

By capturing full
value of global
activities firms
can offer new
products at
significantly
lower price
points and
penetrate new
market
segments/
geographies

Market entry. Companies have entered new countries in order to expand their
consumer base, using a very similar production model in the foreign country to
the one they operate at home (e.g., global expansion strategies of
multinational companies in food retail, auto, and retail banking; Exhibit 7).
Product specialization. Companies have located the entire production
process of a product (components to final assembly) to a single location or
region, with different locations specializing in different products and trading
finished goods (e.g., in auto assembly within NAFTA, Mexico produces all
Pontiac Aztecs and trades them for Chevrolet TrailBlazers produced in the U.S.;
Exhibit 7).
Value chain disaggregation. Different components of one product are
manufactured in different locations/regions and are assembled into final
product elsewhere (e.g., Mexico has focused on final assembly for the North
American market, using mostly components manufactured in Asia; BPO
investments in India can be very narrowly defined parts of broader business
operations in the U.S.; Exhibit 8).
Value chain reengineering. After moving value chain steps to new location,
processes can be redesigned to capture further efficiencies/cost savings most
importantly, to take advantage of lower labor costs in developing countries
through more labor-intensive methods in (e.g., increasing shifts in IT/BPO and
reducing automation in auto assembly; Exhibit 8).
New market creation. By capturing full value of global activities, firms can
offer new products at significantly lower price points and penetrate new market
segments/geographies (e.g., increased service level through phone for bank
customers in developed economies; offering lower cost products in developing
countries, such as cars in India and PCs/air conditioners in China; Exhibit 9).
MARKET SEEKING AND EFFICIENCY SEEKING INVESTMENTS
The 1990s saw a real boom in multinational company investment in developing
countries (Exhibit 10). This boom included both market-seeking investments
made in order to gain access to the host country markets still the dominant
motive for international expansion for companies; and efficiency-seeking
investments made to reduce global production costs of multinational companies.2
We make a further distinction within market-seeking FDI depending on whether
government policy barriers preventing imports created an incentive for investing
within the host country (Exhibit 11).
Efficiency-seeking FDI is motivated by multinational companies seeking to
reduce costs by locating production to countries with lower factor costs.
Among our sectors, consumer electronics in Mexico and partly in China, auto
in Mexico, and IT/BPO sectors in India were motivated by MNCs looking for
more efficient production locations for products and services sold mostly
2.

An additional major factor contributing to large FDI inflows to developing countries in 1990s
were large-scale privatizations in many developing countries (e.g., Brazil, Mexico). We did not
have cases directly related to privatization in our sample and have excluded them from our
scope. Similarly for the two other motives for foreign direct investments: resource-seeking or
technology-seeking investments.

Exhibit 7

GRAPHICAL DEPICTIONS OF STAGES OF GLOBAL INDUSTRY


RESTRUCTURING
Market entry

Product specialization

Retail

Auto

Chevrolet TrailBlazer
(Dayton, OH)

a
Tr

Wal-Mart

Mexico

de

Pontiac Aztek
Ramos Arizpe, Mexico
Wal-Mart
Brazil

Source: Interviews; McKinsey analysis

Exhibit 8

GRAPHICAL DEPICTIONS OF STAGES OF GLOBAL INDUSTRY


RESTRUCTURING (CONTINUED)
Value chain disaggregation

Value chain reengineering

Consumer electronics: PCs

Offshored Services

China:
motherboards
mouse, keyboard,
monitor

U.S.: sales
and marketing

Korea
DRAM
Taiwan
design
Thailand: hard
drive
Malaysia:
MPU

Source: Interviews; McKinsey analysis

Mexico:
assembly

Exhibit 9

OPPORTUNITY TO DEVELOP NEW MARKETS AFTER GLOBAL COST


OPPORTUNITY CAPTURE
Supply
current

Price

Supply global
opportunity

Demand

Quantity
Significant market growth
opportunity if global cost
opportunities captured

Source: Interviews; McKinsey analysis

Exhibit 10

FDI INVESTMENT IN DEVELOPING COUNTRIES HAS RAPIDLY


INCREASED AND IS MAINLY MARKET SEEKING
Inflows
U.S. $ Billions
300
250
200
150
100

~ 80% of
FDI is
market
seeking*

50
0
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

* Based on estimates from OECD 2000 segmentation of total FDI (developed and developing countries); excludes
resource seeking FDI (e.g., for petroleum); with this category, FDI is 84% market seeking
Source: OECD; McKinsey Global Institute; WDI

Exhibit 11

FDI TYPOLOGY BY MOTIVE OF INVESTMENT

Consumer
electronics, China
Manufacturing

Auto, Brazil
Auto, China
Auto, India
Consumer
electronics, Brazil
Consumer
electronics, India

Auto, Mexico
Consumer
electronics, Mexico
Consumer
electronics, China

Sector type

Services

IT
BPO

Food retail, Brazil


Food retail, Mexico
Retail banking,
Mexico
Retail banking,
Brazil

Pure market seeking

Tariff-jumping

Efficiency seeking

Motive for entry

Exhibit 12

FDI TYPOLOGY AND OVERALL FDI IMPACT ASSESSMENT

Very
positive

Positive
Overall
FDI
impact

Consumer
electronics, China

Auto, India

Auto, Mexico
Consumer
electronics, Mexico
Consumer
electronics, China
BPO

Food retail, Mexico


Food retail, Brazil
Retail banking,
Mexico

Auto, China
Consumer
electronics, Brazil
Consumer
electronics, India
Auto, Brazil

IT
Efficiency seeking
FDI is
overwhelmingly
positive
For market seeking,
impact ranges from
neutral to very
positive

Retail banking,
Brazil
Neutral

Negative

Pure market
seeking

Tariff jumping

Efficiency seeking

Motive for entry


Note: Exhibit 23 provides the background on each component of FDI impact in each case study.
Source: McKinsey Global Institute

outside of the host country.


Pure market-seeking FDI is motivated by MNCs looking for revenue growth
by expanding their operations in other countries. Both food retail and retail
banking cases belong to this category. In addition, the rapidly growing
domestic market in China adds market-seeking motive to FDI in China
consumer electronics sector, so that both motives are driving the current
investment boom.
Market seeking FDI to overcome policy barriers or tariff-jumping FDI
refers to cases where import barriers limit foreign companies' capacity to supply
local demand through imports, and as a result they end up investing in plants
for domestic production only. The auto sector cases fit this category, except
Mexico, as do the highly protected consumer electronics sectors in India and
Brazil.
LARGE ECONOMIC VALUE CREATION THROUGH FDI
In our sample, we found FDI to have created substantial economic value within
host countries. In 13 out of our 14 case studies, we found FDI to have had an
overall positive or very positive economic impact. This finding strongly suggests
that many of the criticisms directed at foreign operations in developing countries
e.g., that they act as monopolies, lay off workers, without generating spillover
effects on the rest of the economy are not broadly warranted. And while we
found a positive impact across the different sectors and varying policy regimes, we
found a clear pattern by type of FDI (Exhibit 12).
Efficiency-seeking FDI overwhelmingly had a positive impact on the host
countries. It consistently had a positive or very positive impact on sector
productivity, output, and employment. At the same time, focus on exports
meant that these investments did not have significant costs to incumbent
domestic companies. This explains the focus of many developing country
policy makers on boosting export-oriented FDI even while keeping domestic
services closed to foreign investors (e.g., India).
Two typical examples of efficiency-seeking FDI are consumer electronics in
Mexico and business process offshoring (BPO) in India. In both cases, foreign
companies serving the U.S. market have located a specific part of their value
chain in a lower labor cost country (final assembly for white goods and audiovideo equipment in Mexico; labor-intensive data management and customer
support in India), and created a new, rapidly growing sector with large
employment within their host countries.
This overwhelmingly positive impact goes against the view that efficiencyseeking multinational companies are exploiting their host countries because
they pay low wages and provide fewer benefits than they would at their home
markets. In fact, beyond the positive economic impact, we found that in
almost all of cases both efficiency and market seeking ones foreign players
paid a wage premium above their domestic competitors, and they were more

10

Exhibit 13
Auto India

POSITIVE FDI IMPACT ON PRODUCTIVITY CAEM THROUGH INCREASED


COMPETITIVE INTENSITY
Labor productivity
Equivalent cars per equivalent employee; indexed to 1992-93 (100)
PAL produced 15,000 cars* and
employed 10,000 employees* while
Maruti produced 122,000 cars* with
4000 employees* in 1992-93

Increased automation,
innovations in OFT and
supplier-related initiatives
drove improvement

Less productive than Maruti


mainly due to lower scale and
utilization (~75% of the gap)

84

356

156

Increase primarily
driven by indirect
impact of FDI that
increased
competition and
forced improvements
at Maruti

144
100

38

Productivity in Improve1992-93
ments at
HM

Improvements at
Maruti

Exit of PAL

Indirect impact of FDI


driven by competition
* Actual cars and employment (not adjusted)
Source: MGI; McKinsey Global Institute; team analysis

Entry of
new
players

Productivity in
1999-00

Direct impact
of FDI

11

likely to comply with labor regulations than domestic companies within the
same sector.
Market-seeking FDI also had a generally positive impact on sector
productivity and output, the improvement coming in most cases at a
cost to domestic incumbent companies. We saw some differences in
outcomes depending on the policy and competitive environment of the sector
however:
In pure market-seeking cases, FDI tended to improve sector productivity.
Our food retail cases are examples where foreign player entry had a positive
impact on the domestic sector performance although the impact came in
very different ways. In Brazil, MNCs took equity positions in 90 percent of
modern retailers, and provided the capital that allowed them to improve
productivity in distribution and marketing, and seek to gain share by
acquiring modern informal players. In Mexico, Wal-Mart acquired a leading
modern retailer and introduced aggressive pricing and best practice transfer
in operations and supply chain management. This change in competitive
dynamics has led other leading domestic food retailers to similar operational
improvements that are likely to improve sector productivity going forward.
In both food retail cases, the productivity improvements come at a cost to
the domestic incumbents who saw their margins decline as foreign player
entry increased competition. And while the impact of foreign players on
employment has been neutral until now, we expect the productivity
improvements to lead to decline in employment going forward as larger
formats continue to gain market share.
In cases where FDI was motivated by tariff jumping, we found FDI also to
have a consistently positive impact on sector performance. Given the
protection provided to the sector, a very low level of performance was
typical, allowing for significant positive impact even when the tariffs or other
regulations limited FDI's full potential impact. As a result of tariffs or unique
standards limiting trade, and barriers to foreign player entry, sectors like
Brazilian consumer electronics or Indian auto were starting from a very low
productivity base and had consumer prices significantly above world prices.
When policies to FDI were liberalized and foreign players entered to supply
the protected domestic market, increased competition led to improved
productivity of the sector. This impact came both directly as in the case
of productivity improvements in Brazilian consumer electronics companies
that were acquired by foreign players and indirectly, as in the case of the
Indian auto sector where increased competitive pressure led to player exit
and productivity improvements in the leading domestic player, Maruti-Suzuki
(Exhibit 13).
The biggest beneficiaries of foreign players' entry into the protected markets
were consumers who saw declining prices, broader selection, and increasing
domestic consumption. As a result of output growth, the impact on
employment was neutral in most cases, as sector growth helped keep
employment levels stable despite increases in labor productivity. However,
the remaining protected policies kept prices higher and domestic sales lower
than they would be with more liberal policies. A good example of the cost of
the remaining policy barriers is the case of consumer electronics in India,

12

Exhibit 14
China

RETAIL PRICES FOR MANY CE GOODS ARE SIGNIFICANTLY


LESS EXPENSIVE IN CHINA THAN IN INDIA

India

U.S. Dollars, 2002

4,061

2,670

2,443

White
goods
exhibit the
largest price
differences

1,578

171

285

129

Mobile
handsets

263

Color TVs

188

122

Dishwashers Refrigerators Laptops

Source: Euromonitor; McKinsey Global Institute

Exhibit 15

CONSUMER ELECTRONICS PENETRATION RATE IS MUCH HIGHER IN


CHINA THAN IN INDIA

India

Percent of total population

China

93

40
24
14

18

Mobile
handsets

* Black and white


Source: Literature searches

13
0
<1

TVs*

PCs

Refrigerators Window unit


air conditioners

13

where higher prices have kept penetration rates of refrigerators and TVs
significantly below the rates in China (exhibits 14, 15).
The one exception to the rule was retail banking, where the nature of retail
banking limited the potential impact of FDI to capitalization of the sector and
some productivity gains.3 While in Mexico foreign capital played a key role
in capitalizing and stabilizing the local financial system, direct benefits to
consumers or local companies have been limited in both Mexico and Brazil,
because of the nature of the sector and the market conditions in the two
countries:
First, retail banking in general tends to limit competition because of high
switching costs for consumers and high entry barriers like the need to
develop large branch networks and this applies to both foreign and
domestic players.
Second, two characteristics further reduced incentives for competition in
Brazil and Mexico: high interest rates made it very profitable for banks to
lend to the government rather than to consumers, while lack of a longterm debt market has made mortgage lending a segment with relatively
low switching cost very difficult; and there were no significant non-bank
players like money market mutual funds to induce competition (as in the
U.S. banking sector in the 1980s).
And last, leading Brazilian private banks like Itau, Unibanco, and
Bradesco were well capitalized, profitable, and already above the average
productivity level of U.S. banks4, leaving less room for large FDI impact
on the sector stability than in Mexico.
FDI ENTRY LEADS TO POSITIVE SUPPLIER SPILLOVERS
In addition to the clear positive impact on sector performance, we found foreign
player entry to have positive or very positive impact on suppliers in 7 cases, and
neutral in 5 cases.5 The stage of industry restructuring of the sector determined
the potential supplier impact, with some variance on outcomes depending on
sector initial conditions.
In the case of new-market entry FDI when companies need to build a
full value chain within host country to operate we found FDI to lead to
significant supplier spillovers. The one exception was when informality
isolated the informal supply chain from FDI impact. These spillover effects are
illustrated by the food retail cases in Brazil and Mexico and auto cases in India
and China.
Our Mexico food retail case and previous MGI work on retail show the very
3.

4.
5.

Other sectors like public utilities and telecommunications need similarly to be treated differently
because their nature very high economies of scale leading to monopolistic market dynamics,
critical role of regulation make them very different from competitive markets. As a result, the
impact of FDI on the sector dynamics is also likely to be different than that for most other
sectors. As mentioned previously, we do not have studies these sectors and exclude them
from our scope.
McKinsey Global Institute. Productivity, The Key to an Accelerated Development Path for Brazil,
Washington D.C.:1998.
We do not discuss retail banking where there are no significant suppliers.

14

Exhibit 16
Food retail Mexico

ROUGH ESTIMATES

WAL-MART HAS SUCCEEDED IN CONCENTRATING


DISTRIBUTION TO PROPRIETARY CENTERS
Number of
distribution centers

Share of total sales distributed


through centers
Percent

10

Wal-Mart

Comercial Mexicana

Gigante

Soriana

85

20

Regional player in
more developed
Northern Mexico

30

70

All modern players are currently investing on


distribution centers and expect the share of
proprietary distribution to increase over time

Source: Interviews

Exhibit 17
Food retail Mexico

SPILL-OVER EFFECTS TO WAL-MART SUPPLIERS ARE


ALREADY SIGNIFICANT AND LIKELY TO INCREASE
Direct impact on suppliers
Wal-Marts
increasing
market share

Likely outcome

Increasing Wal-Marts negotiation


power

Requires minimum supplier scale


Increasing cross-regional

Increasing supplier concentration

competition for suppliers

Wal-Marts
aggressive COGS
reduction targets

Direct margin and income


pressure

Increased working capital needs


with 30 days payable

Shift to Wal-Mart
distribution
centers

Local and regional distributors

Source: Interviews

become redundant
Loss of distribution revenue to
suppliers with proprietary
distribution channel
Increases marginal cost of
supplying traditional retailers

Rationalization of supplier base


Increased operational efficiency
of surviving suppliers

Accelerating the shift to modern


formats

Some suppliers with proprietary


distribution channels are building
alternative sales channels
(Oxxo & Extra convenience
stores by Coca Cola and Modelo)

15

large spillover potential through supplier productivity improvements in food


processing and distribution. In Mexico, a Wal-Mart-led transition to
proprietary distribution and aggressive supplier price targets increased
competitive pressure among suppliers and led to productivity improvements
through increased scale and productivity-improving investments (exhibits 16
and 17).
The reason these potential benefits were not realized in Brazil food retail was
the high level of informality in food processing, isolating more than 50
percent of the market into an informal market operating under significant
cost benefits from tax avoidance (Exhibit 18).
In the India and China auto sectors, import tariffs and FDI barriers
contributed to the adoption of capital-intensive production methods by
foreign OEMs and rapid localization of the full auto value chain. Indeed, in
China, some OEM investments in parts suppliers actually preceded the entry
of the OEMs themselves. While this has led to rapid growth and productivity
improvements in domestic parts production, the full welfare impact of policyinduced localization is mitigated by the increased costs to domestic
consumers.
FDI in the Mexico and Brazil auto sectors was characterized by product
specialization. Here, the potential supplier impact is again very large as
full value chain production is located within host country, with further
scale benefits from specialization. In Mexico auto, we saw a positive
impact that has created a large sector (more than 7 times the number of
employees than among OEMs themselves), yet with significant further potential
for productivity growth. In Brazil, there has been significant productivity growth
among parts suppliers despite the negative impact on employment caused
by the macroeconomic downturn.
In the case of FDI under a disaggregated value chain, the potential for
supplier spillovers is significantly more limited, as very specific
activities can be located in different parts of the globe with the
exception of the few locations that become global supply basis for key
components. Among our cases consumer electronics illustrates this well.
While China has been able to become the global hub for some electronics
parts, Mexico is very focused on assembly using parts imported from the U.S.
or Asia with very limited backward linkages to local suppliers (Exhibit 19).
And while policy barriers have created final electronics product assembly
operations in India and China, they have not led to significant supplier spillovers
there either.
CONSUMERS HAVE BEEN THE BIG WINNERS
Among all the constituencies within the host country, consumers are the major
beneficiaries as foreign player entry leads to direct improvements in their
standards of living. Consumers saw positive impact through price reductions,
improved selection, or both, and these led to increased output or domestic
consumption in most cases. These benefits were present across both marketseeking and efficiency-seeking cases, and in all sectors except retail banking.

16

Exhibit 18
Food retail Brazil and Mexico

BENEFITS FROM INFORMALITY ARE LOWER IN MEXICO


THAN IN BRAZIL

ROUGH ESTIMATE

Indexed to formal sector net margin = 100


176

Mexico

100

36

14

26

Key advantage for


informal retailers in
Brazil, but not Mexico

Brazil

55
100

Formal
player net
income

40

345

150

VAT and
special
taxes
evasion

Social
security
payment
evasion

Income
tax
evasion

Informal
player net
income

Note: Analysis modeled for a representative supermarket informal sector assumption is that 30% net sales
and employee costs go unreported
Source: McKinsey analysis

Exhibit 19

ROLES COUNTRIES PLAY IN GLOBAL CONSUMER ELECTRONICS VALUE


CHAIN

Demand
market
production
Systems
integration

Specialist
production
Mouses and
key board
Specialist
production
DRAM
production
Specialist
production
Semiconductor
design/production

Specialist
production
MPU design
fabrication

Demand
market
production

Border
zones
production

Border zones
production
Desktop final
assembly

Perform tasks where


good/service cannot
be effectively sourced
outside demand
market due to
structural, policy, or
organizational factors

Perform production
for goods where
transportation
sensitivity outweighs
advantages
presented by
specialist production
zones

Produces goods at
Specialist
production

lowest possible cost


by capturing low labor
costs, economies of
scale/scope, and/or
natural resource cost
advantages

17

This impact on domestic standards of living is the great success story of FDI but
one that is seldom heard because of the fact that consumers are a fragmented,
less vocal political body than, say, incumbent domestic companies.
In market-seeking FDI cases, prices to consumers declined in 7 out of
10 cases, and selection available to consumers grew in all but the retail
banking cases.6 In pure market-seeking cases like Mexico food retail, there
were strong consumer benefits from lower and more transparent prices early
on as foreign player entry increased competitive intensity. Similarly in the case
of tariff jumping FDI: consumers saw declining prices and improved selection
as a result of foreign investments in the protected auto assembly markets in
India, Brazil, and China, as well as in Indian and Brazilian consumer electronics
cases. This price impact was very large in some cases: for example, Chinese
consumers saw passenger car prices drop by more than 30 percent between
1995 and 2001, while consumer prices more broadly grew by 10 percent
during the same time period (Exhibit 20). And sector output and penetration
of sector products (consumer durables in these cases) increased with declining
prices, with the exception of Brazilian auto, where macroeconomic downturn
caused the domestic market to collapse during our analysis period.
As we would expect, we found efficiency-seeking FDI cases to have a
more limited impact on host country consumers as most production is
for export and benefits global consumers. Furthermore, many countries
have imposed policy barriers that prohibit export-oriented FDI players from
participating in the domestic market, e.g., tax incentives tied to exports kept
some consumer electronics companies in Mexico (prior to NAFTA) or kept
Indian IT/BPO companies from supplying their host country markets. But even
in these conditions, we found the presence of foreign players benefits domestic
consumers either in the form of broader selection enabled by local
production, or as in the case of Mexican auto sector, by FDI players introducing
innovative financing options in the Mexican market that they probably would
not have done without having local production facilities.
FOREIGN INVESTMENTS BRING CAPITAL, TECHNOLOGY, AND SKILLS
We attribute the positive impact of foreign direct investments in developing
countries to the combination of three things that foreign players bring in tandem
to the domestic markets: capital, technology, and skills. In many cases, the three
are closely integrated as in automotive plant investments that combine the
capital, technology, and operational and managerial skills needed. In most
successful cases however, these MNC global capabilities were complemented
6.

Outside the case of retail banking discussed above, there were two market-seeking cases
where we did not attribute lower prices to consumers as the impact of FDI. First is the case of
China consumer electronics, where cut-throat competition has led to rapid price declines not
only to Chinese but also global consumers. However, given that the competitive dynamics were
driven largely by Chinese domestic players, we have not attributed that as FDI impact. The
second case is food retail in Brazil, where the benefits of productivity improvements were
passed on to the government in higher taxes rather than to consumers. This occurred because
the MNCs paid high value-added taxes whereas the domestic informal players did not. But
even in this case consumers benefited from broadened product selection.

18

Exhibit 20
Auto China

PRICE EVOLUTION FOR DIFFERENT MODELS IN CHINA


Thousand RMB (nominal values)
200
180
160
Santana 2000

140
120

Average price
decrease of 31%
from 1995 to 2002

Fukang 1.6
Jetta

100

Fukang 1.4

80
60
TJ7100 Charade

40
20
0

1995 1996 1997 1998 1999 2000 2001 2002

Note: List price does not necessarily reflect transaction price; incentives have to be investigated further; other possible
methodological issues include change in car quality
Source: Access Asia; Press Search

Exhibit 21
Consumer electronics

UNIQUE WHITE GOODS CHARACTERISTICS DRIVEN BY TOTAL NEEDS


Local need/condition

Product characteristics

India
Scarcity of water, with high-cost
water supply

Double basin clothes


washer, which allows for
reuse of water

Europe
Heightened environmental
concern and more frequent trips
for food shopping

Smaller, more efficient


refrigerators than
American counterparts

China
Because many families live in
one-room apartments,
refrigerators are often in the living
room; they are often given as
wedding gifts

Refrigerators styled
towards living room decor;
picture frame integrated
for wedding picture

Source: McKinsey Analysis

19

with deep local market expertise provided either by local partners or locally hired
managers.
Capital. Capital inflow from foreign investors was critical for sector
performance in four of our cases. In Brazil food retail, formal domestic players
were cash constrained and needed foreign capital for the productivityimprovements that would enable them to be more competitive against the low
cost informal players; In Mexican banking, domestic banks had been severely
undercapitalized after the financial crisis of 1997, and foreign capital infusion
was critical for capitalizing and maintaining the stability of the Mexican financial
system; in Indian auto and IT/BPO cases, foreign capital was needed to finance
the investments required for sector growth. In addition, supplier spillover effect
in many cases was driven by foreign player financing: auto OEMs are a main
source of financing for local parts suppliers in all country cases, and in China
consumer electronics, financing from Taiwanese entrepreneurs were a
significant source for Chinese companies supplying to or competing with other
foreign investors. Yet the need for capital (either for investments or operations)
was not a necessary condition for foreign player entry there were cases like
Wal-Mart's Cifra acquisition in Mexico food retail that were pure transfer of
equity from a domestic owner to a foreign one.
Technology. Access to proprietary or foreign technologies and design
capabilities was a key factor that foreign OEMs provided in all auto and
consumer electronics cases. The more complex and rapidly evolving the
technology required, the more difficult it is for domestic companies to acquire
without foreign investments. So within consumer electronics, access to foreign
technology was most important in mobile phones and least important in white
goods like refrigerators and stoves.
Skills. Foreign investors brought a broad range of skills that enabled them to
improve domestic sector productivity and grow output. We have grouped these
skills into four categories:
Operations/organization of functions and tasks (OFT). Large foreign players
coming from more competitive home markets brought with them global
capabilities in operations in most of our sectors: examples include supply
chain processes and inventory management in food retail; plant operations
and distribution in auto; business operations in BPO; and credit work-out
skills in retail banking in Mexico.
Marketing and product tailoring. Foreign players also introduced
improvements in marketing: for example, in food retail, foreign players
introduced competitive pricing practices in Mexico and improved in-store
marketing and merchandizing in Brazil; in consumer electronics China and
India, some MNCs tailored products to suit the domestic market
(Exhibit 21).
Interestingly, the most successful examples combined the global capabilities
of foreign players with deep local knowledge provided by their domestic
partners (e.g., Cifra management in Mexican food retail, Maruti in Indian
auto), and where we saw some failures among foreign players as a result of
insufficient local knowledge (e.g., OEMs targeting high-end segments in
India auto, or attempts of foreign retailers to sell ski boots in So Paulo or
sit-on lawn-mowers in Mexico).

20

Exhibit 22
Retail banking Mexico

MNCS ADOPTED BROAD RANGE OF MANAGEMENT APPROACHES IN


THEIR MEXICAN OPERATIONS
Execution focus

Performance pressure

Mentoring approach

Example

BBVA Bancomer

Santander Serfin

Citigroup Banamex

Description

Local management

Local management is given

Local management is given

executes decisions made


by parent company
Little focus on independent
thinking and initiative by
local management

performance targets based


on group benchmarks
Up to local management to
decide how to meet topdown targets

autonomy under guidance


of parent company
executives
Local management
encouraged to adopt best
practice developed in other
parts of the organization

Top management in

Subsidiary run by a

Subsidiary run mostly by

subsidiary replaced by
senior managers from
parent company
Key management decisions
taken by parent company

combination of local and


parent company executives
Operational control by
parent company with clear
line authority over local
management

Clear and direct transfer of

Model emphasizes local

best practice through


central line of command
Approach favours best
practice over local content

content rather than best


practice
Santander fosters best
practice transfer through
internal consulting unit

Internal
organization

Skill transfer

Source: Interviews

local executives

Multiple reporting lines


within matrix-like structure

Mentoring approach tries to


strike balance between
local content and best
practice

21

Managerial and organizational skills. In all our cases, foreign players


brought new organizational and managerial skills to the domestic market.
These ranged from introducing more professionalism in company culture
and increasing accountability, to more specific management tools like
performance measurement or wage structures and other incentives. Again,
we saw examples of MNCs benefiting from local knowledge through
employment of local managers and supervisors particularly on the customer
service segments of Indian BPO.
We found broad variance in the specific management approaches, as we do
among high-performing companies within any developed economy, and did
not find a correlation between, say, level of de-centralization and MNC
performance. The example of Mexican retail banking illustrates the case:
after acquiring domestic banks, MNCs have chosen a broad range of
management approaches ranging from Banco Bilbao Vizcaya Argentaria's
(BBVA) strictly top-down approach to Citigroup's decentralized approach
through management mentoring (Exhibit 22).
Global market access. In efficiency-seeking cases, foreign players provided
access to the export market through their global distribution networks,
market position, and brands. This was the case for all consumer electronics
export segments in Mexico, China, and Brazil, as well as in automotive in
Mexico and Brazil, where foreign OEMs were able to increase exports to
compensate declining domestic sales during economic crises. This can
often be a major barrier for domestic players yet they can potentially
benefit from FDI entry as well: in Indian IT/BPO case, the example of leading
global players like IBM locating their off-shoring operations to India
established the credibility of the Indian sector, opening the door for India
companies to follow suit.
ADDITIONAL IMPACT COMES THROUGH COMPETITION
We found competition within the host country sector to be a critical driver of
improvements in sector performance as a result of FDI. The impact mechanism,
therefore, was not very different from any domestic economy. However, FDI's
potential for impact can be greater because of the combination of scale, capital,
and global capabilities that allowed MNCs more aggressively to close existing large
productivity gaps. And this potential of FDI impact was demonstrated in three
ways:
FDI can be a powerful catalyst to spur competition in industries
characterized by low competition and poor productivity. Examples include
the cases of consumer electronics in Brazil and India, food retail in Mexico, and
auto in China, India, and Brazil.
Competition is also key to diffusing FDI-introduced innovation across an
industry. In Brazilian food retail, high competitive intensity caused by informal
players forced all modern retailers to rapidly increase productivity; in Mexican
and Brazilian auto cases, increasing competition from imports induced foreign
players themselves to increase their productivity.

22

And last, competition is critical for ensuring that the economic benefits
from improved productivity are passed on to consumers through lower
prices. The best example of this is the case of consumer electronics in China,
where aggressive competition has kept supplier margins razor thin and brought
rapidly declining prices to both Chinese and global consumers.
* * *
Increasingly, foreign direct investment are integrating developing countries into the
global economy, creating large economic benefits to both the global economy and
to the developing countries themselves. Industry restructuring enables global
growth as companies reduce production costs and create new markets. For the
large developing countries, integrating into the global economy through foreign
direct investments improves standards of living by improving productivity and
creating output growth. The biggest beneficiaries from this transition are
consumers - both global consumers that reap the benefits from global industry
restructuring, and consumers in the host countries that see their purchasing
power and standards of living improve. The more competitive the environment,
the more benefits FDI can bring - and the more benefits that are passed directly
on to consumers.

23

Exhibit 23

Auto

++ Very positive

Overall positive impact

FDI IMPACT IN HOST COUNTRY

Negative

Mixed

+ Positive

Very negative

Negative

0 Neutral

[ ]

Estimate

Consumer electronics

Food retail

Retail banking
Brazil

Brazil

Mexico

China

India

Brazil

Mexico

China

India

Brazil

Mexico

Level of FDI
relative to sector*
Economic impact
Sector
productivity
Sector output

52%

6.5%

33%

n/a

30%

15%

29%

35%

4.2%

2.4%

n/a

7.5%

++

++

[+]

[+]

0/+

[+]

[++]

++

++

++

++

[0]

[+]

[+]

[+]

[++]

Sector

[]

++

[0]

[]

[+]

[++]

Suppliers

++

[0]

++

[0]

[0]

[+]

n/a

n/a

Impact on
competitive
intensity

++

[+]

++

[+]

[+]

Mexico IT

BPO
2.2%

employment

Distributional impact

Companies
Companies
with FDI
Companies
without FDI

[+]

++

[+/]

[+]

+/

+/

+/

++/

++

[0]

[0]

n/a

n/a

[0/ ]

0/

[0/]

[]

[++]

0
+

+
++

+
+

0
+

[0]
[0]

++
[0]

+
[0]

[+]
[0]

0
[0]

[]
[0]

[0]

[+]
[+]

[++]
[++]

Reduced prices

++

[0]

[0]

++

n/a

n/a

++

[+]

[+]

[+]

[0/+]

[+]

0
0

Selection

n/a

n/a

Taxes/other

++

[0]

[0]

[+]

[0]

++

[0]

[0]

[+]

Overall assessment

++

++

++

++

++

Employees
Level
Wages

Consumers

Government

* Average annual FDI/sector value added in last year of focus period

24

Policy Implications
We did not find evidence that policies targeted at foreign direct investment (FDI),
such as incentives, import barriers, and trade-related investment measures, are
useful tools for economic value creation. In many cases, these policies did not
achieve their objective and they often incurred significant costs. Our case
evidence suggests that governments can increase the value of FDI not by focusing
on targeted FDI policies, but by strengthening the foundations of economic
development, including a competitive environment, an even enforcement of laws
and regulations, and a strong physical and legal infrastructure.
Government policies affect both FDI flow and impact of a given level of FDI. The
goal of targeted FDI policies is to increase FDI flows, but in our sample of cases,
these policies often did not achieve their objective. Rather, FDI flows were driven
by sector market size potential and macroeconomic stability. In addition, targeted
FDI policies reduced the impact of a given level of FDI. By contrast, the main
effect of foundation-strengthening policies is to increase the impact of a given
level of FDI. In our sample of cases, these policies did not have a negative effect
on FDI flows. Rather, because they strengthen the foundations for economic
development, they contributed to creating an attractive environment for FDI.
TARGETED FDI POLICIES DO NOT CREATE ECONOMIC VALUE
In our sample of large developing countries, direct incentives to FDI did not have
a major impact on FDI flows. These incentives did, however, come with
significant costs, including a negative impact on productivity and "race-to-thebottom" dynamics. Import barriers reduced FDI impact by limiting competition
and protecting subscale local operations. Trade-related investment measures
likewise failed to create economic value: local content requirements created
significant costs by protecting low productivity players, but they were not
necessary for the development of strong supplier industries. Finally, we found no
compelling evidence in favor of joint-venture (JV) requirements. Where JVs
provided benefits, they tended to emerge naturally rather than through JV
requirements.
Direct incentives are not justified as a tool to attract FDI
Incentives, such as tax holidays, import duty exemptions, and investment
allowances are popular tools for attracting FDI (Exhibit 1). However, our case
evidence suggests that their popularity is not justified. They were not the primary
drivers of FDI flow and have significant costs that are often ignored by policy
makers.
Incentives are not the primary drivers of FDI flows. In 7 of 14 cases,
governments used incentives to attract FDI. In only 3 cases did the incentives
have a positive effect on the level of FDI (Auto Brazil and India, Business Process
Offshoring (BPO)); in 4 cases they did not influence FDI levels (Auto China,
Consumer Electronics Brazil and China, Banking Brazil; Exhibit 2). But even where
incentives did have a positive effect on the level of FDI, they were not the most

25

26

Exhibit 1

INCENTIVES ARE A POPULAR MECHANISM FOR ATTRACTING FDI

Type of incentive used, 1995


Percent of 103 countries surveyed
65

61
48

46

25

Tax
holidays

Import
duty
exemption

Duty
drawback

Accelerated
depreciation

Investment
allowances

Source: UNCTAD 1995; McKinsey Global Institute

Exhibit 2

INCENTIVES INCREASED LEVEL OF FDI IN THREE OUT OF


Effect
Effect
SEVEN CASES
on FDI
on level
Incentive

Auto

Brazil Significant tax incentives, financing and

of FDI
++

impact

free land offered by state governments


in competition for auto plants

Comment

++
+

Highly positive
Positive
Neutral
Negative
Highly negative

Incentives induced overinvestment leading to


reduced sector productivity

Brazilian states bid away enormous value in


competing for FDI

China Tax holidays offered for FDI players


India Government incentives at state levels

included subsidies of power roads, sales


tax deferrals
Consumer
Electronics

Brazil Several tax rebates/reductions on tariffs

for FDI

and indirect taxes for locating production


in Manaus
Tariff/indirect tax rebates/reductions in
certain products in other states (e.g.,
mobile phones in So Paulo)

China For standard CE companies, 2 year

IT/BPO

Inefficient industry structure with expensive


production in Manaus

Expensive bureaucracy associated with


recovery rebates

tax free, 3 years half tax after first


profitable year
Long-term half-tax (15%) for high-tech
companies
Retail
Banking

Incentives not necessary to attract FDI to China


States bid away enormous value in competing

Given Chinas very attractive market, labor


costs, agglomeration economics, incentives
not necessary to attract FDI

Brazil Tax subsidies to FDI players

Incentives not necessary to attract FDI

India

Incentives not a key driver of decision to locate

Tax holidays and zero import tariff on


imported equipment from federal
government
Subsidies on power, land, cash
payment for job creation, stamp tax
reduction from state government

in India

Interviews show that CEOs prefer that the


government withdraw incentives and invest in
upgrading infrastructure

Note: No incentives were offered in Auto Mexico, Consumer Electronics India and Mexico, Food Retail Brazil and Mexico, and Retail Banking Mexico
Source: McKinsey Global Institute

27

important factors driving location decisions of multinational companies (MNCs),


suggesting that most of the FDI would have been attracted without the incentives.
For example, in both Auto India and BPO, MNCs ranked quality of infrastructure
and availability of skilled labor as more important than government incentives
(exhibits 3 and 4).
Incentives have significant costs that are often ignored by policy makers.
In addition to direct fiscal and administrative costs, incentives had large indirect
costs that rendered them ineffective as tools for economic value creation in the
cases we studied (Exhibit 5).
Direct costs include both fiscal and administrative costs. The fiscal costs of
incentives vary by type of FDI. For efficiency-seeking FDI, incentives constitute
economic costs only if the FDI player would have invested in the country even
without the incentive. For market-seeking FDI, fiscal costs occur whenever an
entrant receives incentives for an investment that would have otherwise been
made by a domestic player. Administrative costs are generated because
bureaucracies are created to administer the incentive programs.
Indirect costs include a negative impact on productivity, "race-to-the-bottom"
dynamics, and the possibility of corruption.
Negative impact on productivity. Incentives may encourage overinvestment,
inefficient production, or crowding out of more efficient producers, all of
which reduce sector productivity. For example, government incentives
encouraged overinvestment by foreign original equipment manufacturers
(OEMs) in Brazil's automotive industry, which contributed to overcapacity
and significantly reduced sector productivity (exhibits 6 and 7). Tax
incentives encouraged foreign consumer electronics manufacturers to locate
production in remote Manaus region of Brazil, which increased costs and
reduced productivity (Exhibit 8).
"Race-to-the-bottom" dynamics. National or subnational governments may
engage in bidding wars that transfer large amounts of value to FDI
companies. For example, Brazilian state governments competed vigorously
for the location of foreign automotive plants by offering large incentive
packages, which transferred significant value from the Brazilian state to FDI
companies (Exhibit 9). Likewise, Indian states bid away enormous value in
competing for the location of foreign automobile plants. For efficiencyseeking FDI, similar bidding dynamics operate on the global level.
Corruption. While we did not find evidence of widespread corruption
impacting economic outcomes, the discretionary disbursement of incentives
does create the risk of corrupt behavior.
Import barriers reduce FDI impact
Our case evidence shows that import barriers reduce FDI impact by limiting
competition and by protecting subscale local operations. Import barriers include
measures such as import tariffs, quotas, and products standards. 7 out of 8
cases in tradable goods sectors had some form of import protection during the
period of our study. In all 7 cases, FDI had a positive impact, but our case
evidence shows that FDI impact would have been even greater in the absence of
import barriers.

28

Exhibit 3
Auto India

INCENTIVES WERE NOT AMONG TOP THREE FACTORS DRIVING FORDS


LOCATION DECISION IN INDIA
Ford was offered a host of incentives to locate
its plant in Tamil Nadu
Government offered Ford
Cheap land

300 acres of freehold land at a


subsidized cost of Rs. 300 million

However, incentives were not the most


important factor driving their location decision
Rankings of factors affecting location decision
10=highest, 1=lowest
Rank

Guaranteed power supply plant will get

Infrastructure
assistance

Fiscal
incentives

power from 2 separate stations (one


being a 230kV)
Ford to get 40% discount on power tariff
in Year 1 although this was gradually
eliminated by Year 5
Adequate piped water supply assured

Distance from international airport

Proximity to target market

Availability of cheap land

Proximity to port/inland container terminal

14-year holiday on sales tax

Incentives

Availability of infrastructure

Availability of skilled labor

Availability of supplier base (ancillary unit)

(now 12%) on cars sold within Tamil


Nadu (~9% of total production)
Holiday on 4% CST on all cars
sold outside Tamil Nadu
Concession on sales tax levied on
bought-out components in production
process
No import duty on capital goods (~30%
at that time) as long as Ford made a
commitment to export 5 times the value
of the duty (subsequently changed)

Note: Taken from Study on policy competition among states in India for attracting direct investment by R. Venkatesan
et al.
Source: Interviews; NCAER

Exhibit 4
BPO

BPO COMPANIES RANK INCENTIVES LOW WHEN EVALUATING


LOCATION ATTRACTIVENESS
Mean rank by companies*

Description

High-quality
infrastructure

10

Easy
availability
of trained
man power

Rules and
regulations/
ease of
setup

Easy
accessibility

Financial
incentives
by state
government

Reliable, cost-effective telecom infrastructure with multiple levels of built-in redundancy


Ready-to-move-in office space
Reliable, economically priced power with multiple levels of built-in redundancy
Reliable public and private transport for rapid movement of employees
Developed certified/recommended vendor-base

Sufficient high quality people trained and certified by leading institutions


Existence of institutions of learning catering specifically to offshoring industry to develop
company- specific courses/modules

Supportive and progressive regulatory environment apart from vary attractive financial
incentives

Single-window interface for facilitating the setting up and running offshoring centers

World-class accessibility with good connections by air

Attractive financial incentives by state government to companies for setting-up and running off5

shoring centers

Financial incentives are low on the list of criteria firms use for location decisions; however, they
can be a significant determinant when all others factors are equal

* Based on a survey of 30 MNC and Indian offshored services companies. Ranking on a scale of 1-10 where 1 denotes lowest and 10
denotes highest importance
Source: McKinsey Global Institute

29

Exhibit 5

DIRECT AND INDIRECT COSTS OF INCENTIVES

Direct cost

Fiscal cost

Administrative costs

Description

Case evidence

Incentives erode tax base when free-riders who would


have invested anyways receive tax breaks
Often tax breaks may be extended to local players to
preserve level playing field

Because there are many discretionary tax breaks, large

Brazil Consumer

bureaucracies to monitor qualification are created


Enforcement can be expensive as well, as there are plenty
of ways to misrepresent

India IT/BPO

Reduced productivity can occur as a result of

Indirect cost

Impact on productivity

Overinvestment
Inefficient production
Crowding out of more efficient domestic producers

Especially within regions with integrated market value


Race to the bottom

destroying incentive wars can develop

Brazil Auto
India Auto
China Auto
India IT/BPO
Brazil banking

Electronics

Brazil Auto
Brazil Consumer
Electronics

Brazil Auto
India Auto

Operates both at the national and sub-national levels


Discretionary disbursement of incentives creates

India IT/BPO

opportunities for corruption

Corruption

Source: McKinsey Global Institute

Exhibit 6
Auto Brazil

INCENTIVES CONTRIBUTED TO CAPACITY BUILD-UP IN BRAZILS


AUTO SECTOR
Capacity in Brazil Auto sector, 1995-2001
Thousand units per year

3,000
340
380
1,800

1995
capacity

Collectively, the
industry built
more than
double what
would have
been expected
under long-term
trends

480

Investments
based on
long-term
growth
trends

Source: McKinsey Global Institute

Additional
investments,
due to great
expectations
for future
growth

Further
investments,
due to
incentives,
Sweetners,
and the race
to grow

2001
capacity

30

Exhibit 7
Auto Brazil

OVERCAPACITY SIGNIFICANTLY REDUCED SECTOR PRODUCTIVITY


2001 U.S. $ Thousands per employee

9
12
46

31

42

Existing
plants made
steady
improvements
throughout
the decade
New plants
were superior
in every way,
but the
additional
capacity
created a
drag on
productivity
for old and
new plants
alike

13
19

1990

Capital
(old
plants)

OFT
(old
plants)

Utilization

1997

Capital
(old
plants)

OFT
(old
plants)

Key changes

Increased automation and

Capital

2000

and superior equipment, but old


plants continued to improve as well

Outsourcing, de-

New plants had better facility lay-

bottlenecking, and
continuous improvement
programs

out and external logistics; also


younger workers but old plants
also improved their operations
Capacity increased rapidly as
demand capsized. Overcapacity
was especially high at some new
plants

Rising demand outpaced

Utilization

Utilization

New plants had more automation

machine upgrades
OFT

Mix
shift to
newer
plants*

increases in capacity

Note: Old plants are those built before 1990


* Additional productivity due to new plants is weighted by the fraction of capacity in 2000 that is new
Source: Interviews; plant visits; team analysis

Exhibit 8
Consumer Electronics Brazil

TAX INCENTIVES ENCOURAGE PRODUCTION IN MANAUS REGION


DESPITE SIGNIFICANT COST DISADVANTAGE
Location

Cost advantage*
Percent
Tax incentives for
locating production
in Manaus

Cost penalty
for producing
in Manaus

Manaus

100

Belm

15
6

So Paulo
80

Manaus is located in the middle of the


Amazon forest, around 2,500 miles from
So Paulo, the main consumer market
Cost
So
Paulo

IPI tax
(15%)

VAT

Import
tax + IPI
of imported
items

Inventory Freight***
cost **

Cost
Manaus

Trucks proceed to Belm by river


(5 days) then by road, taking
10-20 days to get to So Paulo

Freight cost between 3% and 7% for CE


products (except white line)

* Assuming a consumer electronics product with 25% of cost as imported components and 20% margin. Labor cost
differences not assumed
** Assume 2 month component stock and 18 days delivery to south-east
*** Assume only extra freight cost compared to So Paulo
Source: Interview, McKinsey analysis

31

Exhibit 9
Auto Brazil

GOVERNMENT INCENTIVES TRANSFERRED LARGE AMOUNT OF VALUE


TO FDI COMPANIES
NPV in $ thousands/job, percent of GDP/capita
At exchange rate
Percent of PPPadjusted GDP/capita

2,380%
810%

182

180

90%

28

Germany VW
(1997)

U.S. 7 plants*
(1980s)

Brazil
3 plants (199596)

* Excludes a single U.S. Mercedes Benz plant with incentives of $168,000 per job in 1994
Source: Cited in Donahue (U.S.); Bachtler et. al. (Europe); Da Mota Veiga and Iglesias (Brazil), and Venkatesan et.al.
(India); McKinsey Global Institute

Exhibit 10
Auto China

CHINAS AUTO SECTOR TARIFFS ARE HIGH IN


INTERNATIONAL COMPARISON

Car (displacement >3.0 L)


Car (displacement <3.0 L)
Parts Bumper and Seat Belt
Parts Air Bag
Parts Gearbox for car

Tariffs in Chinese auto sector


Percent

160

Tariffs for passenger cars

140

China:

120

At WTO entry: 51.9%

100

2006: 25% (any engine)

(<3.0L) and 61.7% (>3.0L)

Other countries:

80

Other countries studied in


this report

60

India: 105%

40

Brazil: 35%
Mexico: 20%

20
0
1995

OECD
Germany: 10%

1996

1997

1998

1999

2000

2001

2002

USA: 2.5%
Japan: 0%

Source: China customs yearbook

32

Exhibit 11
Auto China

CAR PRICES ARE HIGHER IN CHINA THAN IN THE U.S. MAINLY


DUE TO HIGHER PROFIT MARGINS FOR OEMS AND SUPPLIERS

ESTIMATE

Comparison of China and U.S. passenger vehicle prices


Percent
170

10
160
20-25
10-20

0-5

100

20-30
5-10

-10-20

Lower
TFP

Lower
labor
costs

Higher profits margins


for OEMs and suppliers

Actual
price in
China

Additional
taxes
and
fees

List price Value


in China added
tax in
China

DiffeHigher
rence
Invenin profits tory
costs

Difference
in cost
of components

Price in
U.S.

Source: Interviews; McKinsey Global Institute

Exhibit 12
Auto China

SUPPLY AND DEMAND IN CHINA AUTO SECTOR, 2001

ESTIMATE

Price
$ Thousands
20.0
17.5
(1,100, 16.1)
15.0

Dead
weight
loss

Due to constrained

Excess profits*

World
price

12.5

(1,500, 11.0)
10.0

World profit level

Demand

7.5
Unmet
demand

5.0
2.5
0.0
0

200

400

600

Supply curve
* Includes excess profits of parts makers
Source: UBS Warburg; McKinsey analysis

800

1,000

1,200

Sales units

1,400

1,600

1,800

supply and tariff


protection unmet
demand is ~400,000
units (not including
income effects
in future)
Deadweight loss
is approximately
$900 million
Excess profits*
are $3 billion

33

Auto China: Import barriers have been a key inhibitor of greater FDI impact. A
combination of high import tariffs and quotas has limited competition in both
auto assembly and parts, causing prices to remain nearly 70 percent above
U.S. levels (exhibits 10-12).
Consumer Electronics India: Import tariffs average about 30 to 40 percent
for goods such as TVs, PCs, and refrigerators. The protection of domestic
players has limited competition and increased prices by significantly compared
to international best practice levels (exhibits 13 and 14).
Auto India: High import tariffs have forced OEMs selling very small volumes
(e.g., Daimler-Chrysler) to set up plants in India. Due to the small scale of
these plants, OEMs produce with a significant cost-disadvantage, reducing
productivity (exhibits 15-16).
Consumer Electronics Brazil: Brazil-specific standards (such as the unique
PAL-M TV standard) encourage low productivity, subscale local production.
Trade-related investment measures do not create economic value
We did not find compelling evidence in favor of trade-related investment measures
(TRIMs). TRIMs tend to impose requirements or restrictions on company
operations, which can limit their flexibility to compete effectively. Thus they should
not be put in place except in the rare cases where there is strong evidence of
positive outcomes from doing so. In our sample of cases, local content
requirements (LCRs) created significant economic costs by protecting lowproductivity players, but they were not necessary for the development of strong
supplier industries. We found no compelling evidence in favor of joint-venture (JV)
requirements. Where JVs provide benefits, such as access to markets or
governments, they tend to emerge naturally rather than through JV requirements.
Local content requirements create significant economic costs by protecting low
productivity players, but they are not necessary for the development of strong
supplier industries. The primary purpose of LCRs is the development of local
supplier industries. LCRs were present in 3 of 14 cases (Auto China and India
and Consumer Electronics Brazil).
LCRs create significant costs by protecting low productivity players. In
Auto China and Consumer Electronics Brazil, most locally sourced parts are
more expensive than imports due to the small scale of local operations. In
Auto India, local parts were initially more expensive than imports, but, over
time, the Indian parts industry developed an export platform, which reduced its
scale disadvantage. LCRs may have provided a short-term catalyst for the
development of a domestic supplier industry, but interviews suggest that longterm growth has been driven by sector characteristics (low-cost/high-skill labor
and high competitive intensity) rather than LCRs.
Our case evidence suggests that LCRs are not necessary for the
development of strong supplier industries. In Auto China and India, exportoriented supplier industries have developed in the presence of LCRs, but
sectors without LCRs, such as Auto Mexico and Consumer Electronics China
have even more developed supplier industries. Given spillover effects from

34

Exhibit 13
Consumer Electronics India

HIGH TARIFFS LIMIT COMPETITION AND INCREASE PRICES IN INDIAS


CONSUMER ELECTRONICS SECTOR
Average tariff/effective
rate of protection on
final goods
Percent

TV example Color TV price breakdown


Index, International Best Practice = 100
Includes raw
material, conversion
costs and margin

130
Mobile*
phones

14

The protection offered by


import duties on domestic
players finds to mask
inefficiency

100

39

PCs

9-12
Refrigerators

39
Retail
price

International
best
practice
price

30

TVs

8-10

30
Import duty Import duty Higher
on finished on raw
margin
good
material

8-13
Inefficiency
in the
process

Source: McKinsey CII report

Exhibit 14
Consumer Electronics India

IMPORT DUTIES INCREASE PRICES OF INPUTS FOR INDIAS CONSUMER


ELECTRONICS INDUSTRY BY UP TO 30 PERCENT COMPARED TO CHINA
India
China

Import duty on
raw material
Percent
30

CPT

Increase in final
good cost
Percent

30

+10% to TV cost

21

+1% to TV cost
+ 3% to
refrigerators

11

+3% to TV
refrigerators

25

+2% for assembly


+4% for capital
intensive inputs

60

1,010

30

805

10

37

15

Aluminum

Price
difference
Percent

42

10

Plastic

Capital
equipment

Price
Dollar per unit or ton

33
25

N/A

Source: McKinsey CII report; McKinsey Global Institute

35

Exhibit 15
Auto India

IMPORT BARRIERS FORCE SUBSCALE OEM OPERATIONS IN INDIA

Scale of production, 1999-2000


Thousand cars per plant

408
Small scale as a result of import
barriers forcing OEMs selling small
volumes to set up plants in India

100
62
25
Indian postliberalization
plants without
Maruti

Maruti**

Minimum
efficient
scale for
Indian
automation

Indian postliberalization
plants without
Maruti at full
utilization*

* With two shifts


** Including MUV
Source: Interviews, SIAM, Harbour report

Exhibit 16
Auto India

LOWER PRODUCTIVITY OF MNCS LARGELY DRIVEN BY LACK OF SCALE


AND LOW UTILIZATION
Equivalent cars per employee*, indexed to U.S. average

52
19
27

22
5
Pre-liberalisation
plants

Causes

Excess
workers,
OFT, DFM,
technology

Post-libera- Skill
lisation plants
(excl. Maruti)

Less
experience

Supplier
relations

Scale/
Utilization

Less JIT
Lower

Smaller scale
Less indirect

product
quality

labour per car


produced
Higher output

* Excluding sales, R&D, powertrain, etc., and adjusted for hours worked per year
Source: Interviews, SIAM, INFAC; McKinsey Global Institute

Maruti

36

OEMs and the inherent attractiveness of the economics, a strong supplier base
would have likely developed in Auto China and India without the help of LCRs.
In Consumer Electronics Brazil, by contrast, in the absence of the right
economics, LCRs did not create a viable components industry. As soon as
tariffs were reduced, the industry was decimated by lower price imports.
We found no compelling evidence in favor of JV requirements. Where JVs provide
benefits they tend to emerge naturally, rather than through JV requirements.
Governments impose JV requirements for a variety of reasons, including the desire
for greater technology transfer, access to global markets, and the transfer of
management know-how. JV requirements were present in 3 of 14 cases (Auto
China and India and Consumer Electronics China).
Auto China and India: JVs in Auto China provided FDI players with access to
government purchasing and facilitated government relations more broadly.
However, these JVs would likely have emerged naturally given the strong role of
the state in the Chinese economy and the need for a local partner in managing
that relationship. A negative consequence of JV requirements in Auto China
was that they significantly reduced the total amount of FDI during the period of
our study because of lengthy delays in negotiations with the government
(Honda and GM spent over 4 years negotiating with the Chinese government
to set up JVs). In Auto India, when the government relaxed a 50/50 JV
requirement, the share of domestic partners declined to under 10 percent.
Consumer Electronics China: Local companies gained technology from FDI
players, either through JVs or through other forms of collaboration, particularly
in mobile phones. Interviews suggest that FDI players would have entered the
Chinese market through JVs even in the absence of JV requirements, given the
strong role of state in the Chinese economy and the need for access to local
distribution networks and market knowledge.
Food retail Brazil and Mexico: In Brazil, Sonae and Ahold successfully used
JVs as entry vehicles that led to acquisitions. In Mexico, Wal-Mart used a
50/50 JV with an option to acquire its domestic partner as a successful entry
vehicle. There were no JV requirements in either Mexico or Brazil.
GOVERNMENTS CAN INCREASE FDI IMPACT BY PROMOTING A
COMPETITIVE ENVIRONMENT, ENFORCING LAWS AND REGULATIONS, AND
BUILDING A STRONG INFRASTRUCTURE
With competition in the host country sector being the most powerful factor driving
FDI impact, the key policy implication for host country governments is to promote
a competitive environment. Governments can further increase FDI impact by
enforcing laws and regulations and by building a strong physical and legal
infrastructure.

37

Promoting a competitive environment


Our case evidence shows that governments can increase the impact from FDI by
promoting a competitive environment. Specific policies that enhance competitive
intensity include:
Removal of FDI barriers. Competitive intensity in the Indian auto sector
increased dramatically following the removal of FDI barriers. Sector productivity
increased significantly because of the entry of more productive foreign players
and because incumbents were forced to adapt or exit (Exhibit 17). In Auto
China, FDI barriers markedly reduced FDI inflow (each player had to negotiate
a specific entry agreement with the government), which reduced competition
and allowed prices to remain nearly 70 percent above U.S. levels (exhibits 11
and 12). FDI barriers were gradually reduced in the late 1990s/early 2000s,
which prompted an increase in competition and a decline in prices.
Reduction of import barriers. In Auto Brazil, a two-tiered tariff encouraged
OEMs to build local plants. When tariffs were reduced, competitive intensity
increased, resulting in higher productivity and better quality vehicles at lower
prices (Exhibit 18). In Auto Mexico, reductions in import tariffs following NAFTA
led to an increase in competition as Mexico-based producers were increasingly
exposed to the superior quality and productivity of vehicles made in the U.S.
Elimination of local content requirements. LCRs in Auto China and
Consumer Electronics Brazil have limited competition from more efficient
foreign suppliers, which has increased input prices for manufacturers. In Auto
China, LCRs have been removed in the course of the WTO entry and industry
experts expect an increase in competitive intensity as a result.
Promotion of new entrants. Competition in the Mexican retail banking sector
has been limited in part because of the small presence of non-bank players in
core banking markets.1 The Mexican government recently streamlined the
regulation of mutual funds to increase their appeal as investment products and
to increase competition with banks on the deposit side (Exhibit 19). In the
U.S., growth of mutual funds in the 1980s led to a dramatic increase in
banking sector competition.
Enforcing laws and regulations
Unequal enforcement of laws and regulations can have a major impact on sector
performance and FDI impact. Informality the failure of business activities to
meet key legal and tax requirements was a significant problem in many sectors,
reducing productivity growth and formal player performance. Corruption, by
contrast, did not surface as a main issue or barrier to FDI impact.
In countries with high taxes and low tax enforcement, informality has reduced
sector performance and FDI impact. We found some form of informality in 9 of
our 14 cases (Exhibit 20). Informal players reduce sector performance in three
1.

Non-bank financial institutions play an important role in the Mexican financial sector. However,
most of these institutions focus on lower-income segments of the population that are not
served by commercial banks. The role of non-bank financial institutions in core banking
segments is limited.

38

Exhibit 17
Auto India

FDIS MOST CRUCIAL IMPACT IN INDIA WAS TO INDUCE COMPETITION


Labor productivity
Equivalent cars per equivalent employee; indexed to 1992-93 (100)
PAL produced 15,000 cars* and
employed 10,000 employees* while
Maruti produced 122,000 cars* with
4000 employees* in 1992-93

Increased automation,
innovations in OFT and
supplier-related initiatives
drove improvement

Less productive than Maruti


mainly due to lower scale and
utilization (~75% of the gap)

84

356

156

Increase primarily
driven by indirect
impact of FDI that
increased
competition and
forced improvements
at Maruti

144
100

Productivity
in 1992-93

38

Improvements at
HM

Improvements at
Maruti

Entry of
new
players

Exit of PAL

Indirect impact of FDI


driven by competition

Productivity in
1999-00

Direct impact
of FDI

* Actual cars and employment (not adjusted)


Source: MGI; McKinsey Global Institute; team analysis

Exhibit 18
Auto Brazil

IN BRAZIL A TWO-TIERED TARIFF ENCOURAGED OEMS TO BUILD


LOCAL PLANTS
Import tariffs for vehicles*
Percent
Newly elected president
Soaring imports
Trade deficit and Mexican crisis led
to measures to reduce imports

90
80

Automotive import tariff


for non-local players

70
60
50
40
30
20

Automotive import tariff for


local players**

10
0
90
1990

91

92

93

94

95

96

97

98

99

00
2000

* Published schedule of tariff reductions


** Only companies with confirmed investments (either expansions or new facilities). Local players have to maintain
a zero or positive company trade balance to benefit from the lower tariffs. Newcomers will have to export enough
to make up for those benefits within 3 years
Source: Anfavea; Banco Central do Brasil; Conjuntura Econmica; Suma Econmica; Dinheiro Vivo; press clippings

39

Exhibit 19
Retail Banking Mexico

IN MEXICO MUTUAL FUNDS INCREASINGLY COMPETE WITH BANKS FOR


RETAIL DEPOSITS
Total deposit volume of retail mutual funds, 1997-2002
1997 P$ b
Reform of Mutual Funds
Law to promote mutual
funds investments

145.0

152.2
CAGR
19.2%

94.3

Share of total
deposits**:

88.0

63.2

65.5

1997

1998

1999

2000

2001

2002*

8.2%

8.7%

16.4%

11.7%

16.7%

17.9%

* September 2002
** Commercial banks, savings-and-loans, credit unions and retail mutual funds
Source: CNBV

Exhibit 20

PRESENCE OF INFORMALITY ACROSS SECTORS


MGI definition
of informality
Characteristics of the business activity

Full reporting of all


business revenues
and employment

All sectors

Registered as a
business entity but
partial reporting of
business revenues
and employment

Not registered as a
business entity

Food retail:
Significant in
Brazil but not in
Mexico

Modern

Auto parts

Type of
companies

Food retail:
Exists in Mexico
Traditional

Source: Interviews; McKinsey

Food retail:
Significant in Mexico
but not Brazil
Consumer
Electronics:
Significant in mobile
handset retail in
India

Consumer
Electronics:
Significant in PC
assembly in
Brazil, China, and
India

40

ways: first, they retain a higher market share because of cost advantages from tax
evasion, limiting the growth of higher productivity players; second, they avoid scale
build-up and close relationships with financiers, reducing productivity and limiting
the diffusion of best practice; finally, they distort factor costs (i.e., labor vs.
capital), reducing the incentives to invest in productivity improvements.
Food Retail: In Food Retail Brazil, high VAT on food and high indirect taxes
create a significant cost advantage to modern informal players who can reduce
costs both directly by avoiding taxes and indirectly by purchasing from informal
suppliers (Exhibit 21). While informal players have increased competition in
the food retail sector, their productivity lags significantly behind formal players.
FDI players tried to eliminate some of their informal competitors by acquiring
them, but these acquisitions were largely unprofitable due to the cost of full tax
compliance (exhibits 22 and 23). In Mexico, by contrast, the tax burden on
food retailers is much lower, giving firms in the sector minimal incentives to
evade taxes. As a result, while informality remains the rule among small-scale
traditional players, it has not been a factor in the competitive dynamics among
modern retailers.
Consumer electronics: Informality in PC assembly was present in Brazil,
China, and India. High tax rates and ease of avoidance encourage informality
to develop in this sector (Exhibit 24). Informality provided a significant
advantage in selling highly price-sensitive products in low-income countries,
making MNCs less competitive.
Auto: In the fragmented auto parts sector, tax evasion is pervasive. There is
considerable informality, particularly in secondary auto parts across all of our
countries in the form of contraband, robbery, and piracy. In some cases, OEMs
have taken measures to respond to this threat. For example, Honda in Mexico
promises to replace stolen parts free of charge, reducing the incentives for
trade in stolen Honda parts.
Corruption did not surface as a main issue or barrier to FDI impact. Brazil, Mexico,
China, and particularly India rank in the bottom half of the 91 countries ranked
for corruption by Transparency International (Exhibit 25). Yet in our sector cases,
the foreign players who entered did not perceive corruption to be a key factor
limiting their chances of success, nor did we find it to explain differences in
economic outcomes across sectors or countries.
Building a strong infrastructure
Our case evidence shows that a strong physical and legal infrastructure is an
important enabling condition for FDI impact. A high-quality infrastructure was
most important for efficiency-seeking FDI, where companies base location
decisions on the potential to achieve significant efficiency gains. But the quality
of a country's infrastructure was likewise important in determining the impact of
market-seeking FDI.

41

Exhibit 21
Food Retail Brazil and Mexico

IN BRAZIL HIGH TAXES PROVIDE A SIGNIFICANT COST


ADVANTAGE TO INFORMAL RETAILERS

ROUGH ESTIMATE

Indexed to formal sector net margin = 100

176
Mexico

100

14

36

26

Key advantage for


informal retailers in
Brazil, but not Mexico
Brazil

55

40

345

150

100
Formal
player net
income

VAT and
special
taxes
evasion

Social
security
payment
evasion

Income
tax
evasion

Informal
player net
income

Note: Analysis modeled for a representative supermarket informal sector assumption is that 30% net sales
and employee costs go unreported
Source: McKinsey analysis

Exhibit 22
Food Retail Brazil

CHANGE IN PRODUCTIVITY AND PROFITABILITY WHEN AN INFORMAL


RETAILER IS ACQUIRED BY A LARGE FORMAL RETAILER
ACTUAL EXAMPLE
Percent change

Despite a 32% increase in


labor productivity* . . .
Reals

. . . the net margin evaporates


Percent

4.9

12.2
32%

9.3
-97%

0.1
Acquisition

Pre

Post

Number of
employees

1,460

1,095

-25%

Hours
worked/year/
employee

2,328

2,328

0%

Pre

Post

Gross sales
R$ millions

180

144

-20%

Net sales
R$ millions

163

125

-24%

Gross margin
19
25
Percent
Note: 1) See next page for more detail on causes for observed changes. 2) Margins based on net sales.
* Gross margin per employee hour
Source: ABRAS; PNAD; store visits; interviews; McKinsey

29%

42

Exhibit 23
Food Retail Brazil

DETAIL OF CHANGE IN PRODUCTIVITY AND PROFITABILITY WHEN AN


INFORMAL RETAILER IS ACQUIRED BY A LARGE FORMAL RETAILER
ACTUAL EXAMPLE
Post
acquisition Explanation
Centralization and reduction
1,095

Pre
acquisition
1,460

Number of
employees*
Despite a 32%
increase in
labor productivity . . .

Hours worked/year/

2,328

employee

2,328
No change

Labor productivity

9.3

Gross sales

+32%

Higher prices/less pricing flexibility,

180

144

R $ Millions
163

125

R $ Millions

lower volume

Decrease in service level


Decrease in product customization

-20%

Net sales

Remaining employees work the same


number of hours on average**

12.2

Gross margin/hour

. . . sales
decline and
net margin
evaporates

of customer service employees, but


small increase in employees at HQ

-25%

Full tax compliance

-24%

Gross margin***

19

25

Percent

+32%

Net margin***

4.9

0.1

Percent

-97%

Decreased COGS (inclusion in


centralized purchasing/distribution
and elimination of wholesaler)
Higher prices

Much higher centralized and store


costs (7.5%) and full tax compliance
(5%); but improved COGS/deals from
centralized distribution (8%)

* Estimate. Actual data not available.


** Undocumented informal hours become documented, legal overtime
*** Based on net sales
Note: Figures are rounded.
Source: ABRAS; PNAD; store visits; interviews; McKinsey

Exhibit 24
Consumer Electronics Brazil

HIGH TAX RATES ENCOURAGE INFORMALITY IN BRAZILS


CONSUMER ELECTRONICS SECTOR

EXAMPLE

Price breakdown for a consumer electronics product in Brazil assuming full tax payment
Percent

100.0
4.2
18.0

Almost half of the

9.2
0.4
1.0
41.6

consumer price
are taxes

5.3

9.9

Some taxes are

10.4

Product Manucost
facturer
margin

added up in all
step of the chain,
as CPMF and
PIS/Cofins

Import
tax

Labor CPMF
tax*
tax*

PIS/
Cofins
tax*

IPI
tax

Taxes represent 43.8%


of consumer price
* Consider taxes paid by both manufacturer and retailer
Source: Interviews; McKinsey analysis

VAT Retailer Consumer


tax
margin price

43

Exhibit 25

CORRUPTION PERCEIVED TO BE PREVALENT IN COUNTRIES EXAMINED,


BUT NOT A MAJOR FACTOR IN OUR CASES
Corruption Perception Index*, 2002
Country
Score
1. Finland
2. Denmark
New Zealand

Country examined
in our case studies

9.7
9.5

44. Greece
45. Brazil, Bulgaria, Jamaica,
Peru, Poland
50. Ghana
51. Croatia
52. Czech Republic, Latvia,
Morocco, Slovakia, Sri Lanka
57. Colombia, Mexico
59. China, Dominican Republic,
Ethiopia

4.2
4.0
3.9
3.8
3.7
3.6
3.5

70. Argentina
71. Cote dIvoire, Honduras, India,
Russia, Tanzania, Zimbabwe
77. Pakistan, Philippines,
Romania, Zambia

2.8
2.7
2.6

* Based on surveys from business people, academics, and country analysts


Source: Transparency International; MGI

Brazil, Mexico, China, and


India rank in the bottom
half of the 91 countries
ranked for corruption;
however, corruption did
not surface as a main issue
or barrier to FDI impact

44

A high-quality infrastructure is of critical important for efficiency-seeking FDI,


where companies base location decisions on the potential to achieve significant
efficiency gains.
IT/BPO India: The absence of a reliable power and telecom infrastructure has
been a big deterrent for companies to make investments in India. The
government's liberalization of these two sectors led to a significant upgrading
of infrastructure quality and was an important pre-condition for many FDI
players to locate in India.
Consumer Electronics Mexico: Security issues and the poor quality of the
transportation infrastructure have limited FDI impact. Because roadways are
insecure in Mexico, one percent is added to costs to pay for security. Mexican
freight prices are generally much higher than U.S. prices for similar distances.
Consumer Electronics China: High-quality infrastructure was provided in
business-friendly special economic zones (SEZs), which provided good access
to important inputs such as electricity and telephony.
Infrastructure quality likewise influences the impact of market-seeking FDI.
Consumer Electronics India: The underdeveloped export infrastructure limits
opportunities for FDI-driven exports, which market seekers may otherwise
pursue as a complement to their strategy.
Retail banking Mexico: The underdeveloped legal infrastructure (particularly
the difficulty for banks to repossess collateral assets due to enforcement
problems) limits the ability of banks to develop core banking segments, such
as mortgage lending.
Consumer Electronics Brazil: A large share of Brazil's consumer electronics
production is located in the remote region of Manaus, which incurs a 5 percent
freight penalty and 2 percent inventory penalty as parts from Asia take up to 2
months to arrive, due to poor transport links (Exhibit 8).
SUMMARY
We did not find evidence that policies targeted at FDI, such as incentives, import
barriers, and trade-related investment measures, are useful tools for economic
value creation. In many cases, these policies did not achieve their objective and
they often incurred significant costs. Rather than focusing on targeted FDI
policies, our case evidence suggests that governments can increase the value
from FDI by strengthening the foundations of economic development, including a
competitive environment, an even enforcement of laws and regulations, and a
strong physical and legal infrastructure.

Impact on global industry


restructuring
GREATER OPPORTUNITIES FROM THE TRANSITION TO A GLOBAL ECONOMY
Two trends are shaping the global opportunities landscape for companies: many
previously closed developing economies have removed or relaxed policies limiting
trade and foreign investments; and transactions costs associated with global
businesses both time and money have declined rapidly. These two trends
enable developing economies to be increasingly integrated into the global
economy.
Policy barriers limiting foreign investments have been removed in a
number of large developing economies.
India's selective removal of
prohibitions for FDI entry; Mexico's entry to NAFTA; and Brazil's more liberal
policies toward FDI in sectors like the auto sector are just a few examples
(Exhibit 1).
Transactions costs have declined rapidly as physical transactions costs have
been reduced, telecommunications costs have plummeted, and nearly
instantaneous electronic communications have become the global standard
(exhibits 2 and 3). Companies have therefore been able to reduce costs by
relocating labor intensive steps in their value chain to developing countries with
lower labor costs.
FIVE INCREASINGLY MORE SOPHISTICATED HORIZONS OF INDUSTRY
RESTRUCTURING
Multinational companies have invested abroad for two main reasons: to expand
their customer base by entering new markets (market-seeking investments); and
to reduce costs by locating production to countries with lower factor costs
(efficiency-seeking investments; Exhibit 4). We see the two motives as
increasingly complementary, as companies are forced to reduce costs in order to
be able to expand their markets. We have defined five horizons of industry
restructuring that firms can progress along, ranging from market entry to value
chain reengineering to new market creation. These horizons are not exclusive of
one another, nor necessarily sequential, and can often be mutually reinforcing
(exhibits 5-7).
Market entry. Companies enter new countries to expand their consumer
base, using a very similar production model in the foreign country to the one
they operate at home (e.g., global expansion strategies of multinational
companies in food retail, auto, and retail banking).
Product specialization. Some companies locate the entire production
process of a product (components to final assembly) to a single location or
region, with different regions specializing in different products and trading
finished goods (e.g., in auto assembly in North America: Mexico produces all
Pontiac Aztecs and trades them for Chevrolet TrailBlazers produced in the U.S.).
Value chain disaggregation. Different components of one product are
manufactured in different locations/regions and are assembled into final
product elsewhere (e.g., in consumer electronics, Mexico has focused on final
assembly for the North American market, using mostly components

Exhibit 1

MANY DEVELOPING COUNTRIES HAVE REMOVED OR REDUCED TRADE


BARRIERS OVER THE LAST 10 YEARS
Brazil

Mexico

In 2000, Brazil decreased most tariff rates

The government entered NAFTA in 1994

by 3%
The government offered large
concessions including land, infrastructure,
tax breaks, and low-interest loans in order
to attract FDI in the auto sector

which will remove all tariffs on North


American industrial products traded
between Canada, Mexico, and the U.S.
within 10 years; by 1999, 65% of all
industrial US exports entered Mexico tariff
free

China

India

The weighted average import tariff

Auto licensing was abolished in 1991


The weighed average import tariff

decreased from 43% in 1991 to 20.1% in


1997
China entered the WTO in 2001
The 40% local content requirements in
the auto sector were removed in 2001
The government funded various
infrastructure projects to attract FDI

decreased over 60% from 87% in 1991 to


20.3% in 1997
In 2001, the government removed auto
import quotas and permitted 100% FDI
investment in the sector

Source: Literature searches

Exhibit 2

TRANSPORTATION COSTS HAVE DECLINED OVER TIME


Revenue per ton mile, cents*

12
120
10
100
8

Air freight

6
4

Rail

2
0
1980

Barge**
1982

1984

1986

1988

1990

1992

1994

* Revenue decreases used as a proxy for price decreases; adjusted for inflation
** For inland waterways shipping (e.g., Mississippi River)
Source: ENO Transportation Foundation

1996

1998

Exhibit 3

TELECOM COSTS HAVE FALLEN DRAMATICALLY, PARTICULARY IN


DEVELOPING COUNTRIES
$ Thousand/year for 2 Mbps fiber leased line, half circuit*
1,000
900
800
700
600
500
400
300
200
100

U.S.**

0
1996

1997

1998

1999

2000

Philippines
India
Ireland
2001

* Cost of international leased line for India; cost of long distance domestic leased line in the U.S.; costs are for
January each year; for India, based on Mumbai or Cochin
** U.S. half circuit data is derived by dividing full circuit data by half
Source: VSNL press releases; literature search; Lynx; Goldman Sachs estimates; McKinsey Global Institute

Exhibit 4

MOST MULTINATIONAL COMPANIES INVEST OVERSEAS FOR IMPROVED


ACCESS TO MARKETS AND TO REDUCE OPERATING COSTS
Percent of survey respondents who ranked the following as most important objective

Improved market access

55

Reduce operating costs

17

Source raw materials

Consolidate operations

Develop new product lines

Improved productivity

Develop new technologies

Improved labor force access

Reduce risk

Other factors

Exhibit 5

5 MAIN TYPES OF GLOBAL INDUSTRY RESTRUCTURING


Global industry restructuring

5
4
New market
creation

3
2
Value chain disaggregation

Value chain
reengineering

Product
specialization
Market entry

Companies
enter new
countries in
order to expand
consumer base
(e.g., auto, food
retail and retail
banking) using a
very similar
production
model in the
foreign country
to the one they
operate at home

Entire production
process of a
product
(components to
final assembly)
located in a
single location or
region, with
different regions
specializing in
different products
and trading
finished goods
(e.g., auto)

Different
components of
one product (e.g.,
car engine,
brakes) are
manufactured in
different locations/
regions and are
assembled into
final product
(e.g., consumer
electronics)

After moving
value chain steps
to new location,
processes can be
redesigned
to capture further
efficiencies/cost
savings (e.g,
capital/labor
tradeoffs in
IT/BPO and auto)

By capturing full
value of global
activities firms
can offer new
products at
significantly
lower price
points and
penetrate new
market
segments/
geographies
(e.g., cars in
India)

Source: McKinsey Global Institute

Exhibit 6

GRAPHICAL DEPICTIONS OF STAGES OF GLOBAL INDUSTRY


RESTRUCTURING
Market entry

Product specialization

Food retail

Auto

Chevrolet TrailBlazer
(Dayton, OH)

a
Tr

Wal-Mart

Mexico

Pontiac Aztek
Ramos Arizpe, Mexico
Wal-Mart
Brazil

Source: Interviews; McKinsey analysis

de

Exhibit 7

GRAPHICAL DEPICTIONS OF STAGES OF GLOBAL INDUSTRY


RESTRUCTURING (CONTINUED)
Value chain disaggregation

Value chain reengineering

Consumer electronics: PCs

IT/BPO

China:
motherboards
mouse, keyboard,
monitor

U.S.: sales
and marketing

Korea
DRAM
Taiwan
design
Thailand: hard
drive
Malaysia:
MPU

Source: Interviews; McKinsey analysis

Mexico:
assembly

manufactured in the Asia; BPO investments in India can be very narrowly


defined parts of broader business operations in the U.S.).
Value-chain reengineering. After moving value-chain steps to new location,
processes can be redesigned to capture further cost savings from lower labor
costs (and other differences in factors costs) through more labor-intensive
production methods (e.g., increasing shifts in IT/BPO and reducing automation
in auto assembly).
New market creation. By capturing full value of global activities, firms can
offer new products at significantly lower price points and penetrate new market
segments/geographies (e.g., increased service-level through phone for bank
customers in developed economies; offering lower cost products in developing
countries, such as cars in India and PCs/air conditioners in China).
Horizon 1: Market entry
A large majority of cross-border investments that companies make today in
developing countries are market-seeking in nature. This is because the nature of
some service sectors like food retail or retail banking requires local presence (pure
market-seeking investments), and because of policy barriers limiting trade in
manufacturing, as in auto (tariff jumping investments).
Pure market-seeking investments. Both the food retail and retail banking
sectors have gone through a rapid phase of globalization as leading global
players expanded their operations first to other developed economies, and, in
late 1990s, to developing countries as well.
In food retail, maturing and more competitive home markets (the result of
cross-border activities within developed economies) led to an investment
boom toward developing countries in the late-1990s. Companies like
Carrefour, Ahold, and Wal-Mart have rapidly increased the number of
countries where they are present, using a range of approaches (exhibits 8
and 9).
In retail banking, global banks have dramatically increased their investments
in emerging markets, largely through acquisition of local bank branch
networks. Spanish banks like Santander and BBV have aggressively entered
Latin American markets, while HSBC and Citibank have taken a worldwide
expansion strategy (exhibits 10-12). The removal of previous FDI barriers
has been the key driver of the expansion to developing countries
Tariff jumping investments. Many countries have maintained high import
barriers and tariffs, such as those in the steel and auto sectors, and as a result,
global companies who want to tap into the domestic markets have established
local production facilities in many large developing economies.
In steel, only a few regions in the world have access to high-quality coal and
iron ore or very low cost power (Exhibit 13). However, most production
remains local because of high tariffs limiting trade, strong unions resisting
change, and relatively high transportation costs.

Exhibit 8

INTERNATIONAL EXPANSION BY TOP GLOBAL FOOD RETAILERS


2001-02

Number of new countries entered


1981-85

1986-90

1991-95

13

-1

19

15

21

20

1996-2000

Most
international
expansion took
place in the
second half
of the 1990s

Source: Annual reports

Exhibit 9

ENTRY METHODS FOR INTERNATIONAL EXPANSION


Greenfield

JV/Acquisition

Japan
Developed

Canada
U.K.
Germany

Developing

Mexico
China
Brazil*

Developed

Developing

Switzerland
Greece**
Belgium**

Mexico
Colombia
China
Romania

U.S.
Denmark
Norway
Portugal

Spain
Sweden

Slovakia

Peru

Thailand

Costa Rica
El Salvador

Slovakia Dominican
Republic
Thailand
Argentina

Developed

Czech

Malaysia
Republic Morocco

Developing

Most international expansion


through JV or acquisition

Portugal South Korea


Singapore Spain
Japan
Italy
Brazil
Poland
Chile
Czech
Republic

Required JV entry

Latvia
Lithuania

* Greenfield stores with initial financial partner


** Entered through acquisition of Promodes
Source: Company reports

Tunisia Mauritius
Turkey
Malaysia
Taiwan

Guatemala
Paraguay
Argentina
Brazil

Chile
Indonesia
Nicaragua
Estonia

Most international expansion


through greenfield entry. Some
entry into developing markets
through JV and into developed
market through acquisition of
Promodes in 1999

Typically pursued a
JV/acquisition strategy for new
international market entry

Exhibit 10

SHARE OF FOREIGN BANKS IN BANKING SECTOR EMERGING


MARKETS
Percent

Mexico

1997

2002

1.0

80.0

Chile

42.0

Argentina

46.0

Brazil

38.0

17.0

Korea

25.0

9.5

Indonesia

17.0

7.1

11.3

Thailand

19.4

India
China

57.3

8.0

10.6
7.6

3.3

1.0

Source: TEJ Database, Central Banks, China Almanac of Banking and Finances

Exhibit 11

SANTANDER - OVERVIEW OF MAJOR ACQUISITIONS


AND ALLIANCES
U.S.
First Fidelity* (1991) minority share
Mexico
Start-up of investment banking (1990)
Invermexico (1996)
Grupo Financiero Serfin (2000)
Puerto Rico

Federal Savings Bank (1989)


Caguos Central Savings Bank (1990)
BCH Puerto Rico (1996)

Germany
CC-Bank** (50% in 1987, 100% in 1996)
Direkt Bank start-up (1994)
UK
Alliance with Royal Bank of Scotland (1988)
Portugal
Banco de Commercio Industria de Portugal
(78% in 1993)
Banco de Totta e Acores and Cia de Seguros
Mundial (1999)
Italy
Instituto Bancario San Paolo di Torino (3% in
1995)

ILLUSTRATIVE

Hungary
Inter-Europa Bank
(10% in1996)

Japan
Alliance with Nomura
Securities (1989)
Hong Kong
Opening of branch (1989)

Chile
Creation of pension fund manager (1992)
Integration of 2 leading consumer finance companies (1995)
Banco Osornovy La Union (1996)
Peru
Banco Interandino and Banco Mercantil (1995)
Colombia:
Banco Commercial Antioqueno (1996)
Venezuela
Banco de Venezuela (1996)
Argentina
Banco Rio de la Plata (Private Banking, 1997)
Brazil
Banco Meridional (1997)
Banespa (2000)

* Now Wachovia
** Consumer Credits Bank
Source: Press clippings; annual reports; McKinsey analysis

Exhibit 12

HSBC OVERVIEW OF MAJOR ACQUISITIONS

ILLUSTRATIVE
France
Credit Commercial de France (2000)
Bank Herve (2001)
Germany
Trinkhaus & Burkhardt KGaA (1992)
Luxembourg
Safra Republic Holdings (1999)
Switzerland
Bank Guyerzeller AG (1992)
UK
British Bank of the Middle East (1959)
Antony Gibbs (1980)
James Capel (1986)
Midland Bank (1992)

U.S.
Carroll, McEntee &
McGinley Inc (1965)
Marine Midland Bank
(1980)
First Federal S&L
(1996)
Republic of New York
(1999)

India
Mercantile Bank of
India (1959)

Turkey
Demir Bank (2001)
Greece
Barclays Bank Greece
(2001)
Mexico
Sefrin(1997)
Bital (2002)

Hong Kong
Hang Seng Limited
(1965)
China
Bank of Shanghai (2001)
Argentina
Grupo Roberts (1997)
Brazil
Banco Bamerindus (1997)
Panama
Chase operations (2000)

New Zeland
AMPs retil banking
portfolio (2003)

Source: Annual report; company website, Bloomber, SDC

Exhibit 13

STEEL DISTRIBUTION OF PRODUCTION INPUTS


Million tons

Main sites
Coking coal export sites
Coking coal and iron ore
Iron ore mining sites

Eastern Europe, 19

Western Europe, 90
Canada, 70

CIS, 33

USA, 70

Japan, 60
China, 51

Mexico, 5

Chinese Taipei, 14
India, 17

Brazil, 11
South Africa, 4

South Korea, 26

Australia, 4
South America, 16
Source: Interviews; McKinsey analysis

10

In the automotive sector, many developing countries have prohibited and/or


imposed steep import tariffs to imports up to 105 percent on passenger
cars in India. Global OEMs have established local operations in order to be
able to gain access to the large domestic markets of these countries. As a
result, the global auto market is still largely regionalized (exhibits 14
and 15).
Horizon 2: Product specialization
As interaction costs decline, companies are increasingly taking advantage of
global comparative advantage and economies of scale by concentrating
production of a specific product in a few locations and trading final products
between regions. Regional trade agreements like NAFTA have allowed auto OEMs
to rationalize production across North America by concentrating production of
each model in fewer sites. This has increased scale and raised capacity
utilization, leading to significant improvements in labor productivity (Exhibit 16).
At the same time, companies have been able to use imports to increase selection
available to consumers in Mexico (Exhibit 17).
Horizon 3: Value chain disaggregation
Increasingly competitive markets in developed economies are putting strong
pressure on companies to reduce their costs. Given that complete industry value
chains often cover a broad range of activities, companies in some sectors have
been able to significantly reduce total production costs and increase their
market share by separating different steps in the production process and
locating each step in a country or region with a comparative advantage in that
specific activity. Consumer electronics, apparel, and IT/BPO provide great
examples.
In consumer electronics, final products often consist of many discrete
components with clear scale benefits (e.g., large fixed cost investments in
semiconductors), yet with bulky final products that are costly to transport after
assembly (e.g., refrigerators, PCs). To minimize total production costs, the
production process has been spread across locations where different regions
specialize in different components (e.g., motherboards in China and DRAMs in
Korea), or final goods assembly is close to large end markets (e.g., Mexico for
sales to the U.S. market). This value chain disaggregation allows companies
to optimize production by taking advantage of different factor costs across
countries, not only labor but also costs like land and electricity (Exhibit 18).
In apparel, market requirements vary by product segment demonstrated by
various different patterns of disaggregation: from rapid design-production cycle
for fashion-sensitive segments organized regionally (where designers close to
main end-use markets work with nearby production locations to reduce
turnaround time for which they are willing to pay slightly higher labor costs);
to lower-cost commodity segments optimizing production cost savings across
the globe (searching for lowest cost fabric to be cut and sewn in a low-laborcost environment; Exhibit 19).

11

Exhibit 14

GOVERNMENT POLICIES THAT INFLUENCE GLOBAL INDUSTRY


RESTRUCTURING IN AUTO

Brazil

China

India

Mexico

The Automotive

Quota on total auto imports of

Licensing abolished in

Importing licensing

Regime gave favored


tariff status to
domestic producers;
this 2-tiered tariff
created an incentive
for importers to invest
locally

Trade barriers (e.g.,


greater voluntary
restraints,
standards)

$8 billion in 2002 being phased


out by 2006
Local content requirements
40%, which has already been
phased out as part of the WTO
agreements
Foreign companies are banned
from car financing, a violation
of 2001 WTO agreements
FDIs must partner with a
Chinese company and transfer
its technology

The government has

The government has funded


offered FDIs large
various infrastructure projects
concessions including
(e.g., road construction,
land, infrastructure, tax
development of expressways)
breaks, and lowto attract more FDI
interest loans
Some companies have been
Parana donated
granted a 2-year income tax
2.5 million square
deferral
meters for Renaults The government recently
new auto plants
drafted a proposal to restrict
Paranas loans (up
the number of ports where
to $100 million)
foreign-made cars can be
were to be repaid in
imported, which could create
10 years without
bottlenecks and decrease the
interest or clause
volume of imported cars
regarding currency
devaluations

Government
incentives

1991

practically prohibits the


import of used vehicles

In March 2001, the


government permitted
100% FDI in auto
sector
Import quotas
removed in 2001

Local content requirement of

The government

There are no restrictions on

34% of value-added applies


to passenger cars

Custom procedures and


administrative procedures
make importing overly
cumbersome

reduced excise duties


to 24% on passenger
cars and has
supported
infrastructure
development
Certain states provide
FDIs with fiscal
packages and capital
subsidies

profit, royalty, dividend,


interest payment, and
capital repatriation

Source: Interviews; literature searches

Exhibit 15

LIGHT VEHICLE PRODUCTION SHARES OF OEM GROUPS 2002


Percent
Group

Members

The Americans

General Motors
Ford
DaimlerChrysler

The Europeans

The East Asians

North America

Europe
76

Volkswagen
PSA
Fiat
BMW
Renault-Nissan

28

Toyota
Honda
Suzuki
Hyundai

14

Total production
Million units

16

16

29

68

30

18
13

Observations
Within the Triad, the majority of production is done by local firms
In non-Triad countries, production is spread evenly across groups

* Figures for Renault-Nissan


Source: DRI WEFA; McKinsey analysis

24

12*

19

Non-Triad

60

Others

Japan-Korea

12

Exhibit 16

CAPACITY AND UTILIZATION OF AUTO OEMS IN MEXICO 1995-2001


Thousand units
CAGR
1994-2001
Percent

1,600
Capacity

1,300

Spare
capacity

368

389

1,211

1,800

1,800

372

307

1,338

1,428

1,493

1,600

7.4

2,000
111

2,000

183

-10.9

1,889

1,817

12.0

262

Since 1995,
production
has outpaced
capacity,
resulting in
high
utilization
rates

Production 932

1995

1996

1997

1998

1999

2000

2001

72

76

84

80

83

94

91

Utilization
Percent

Veteran
OEMs have
expanded
capacity at
existing
plants, rather
than build
new plants

Note: Capacity figures are estimates


Source: AMIA; CSM worldwide

Exhibit 17

SPECIALIZATION IN PRODUCTION DIVERSITY IN SALES


Number of models
Production

39

33

31

33

35

33

31

1995

1996

1997

1998

1999

2000

2001

Sales

Liberalization of
imports has allowed
OEMs to specialize
while offering more
variety to domestic
consumers

Units per model

82

96

103

128

78

114

146

1995

1996

1997

1998

1999

2000

2001

Source: Marketing Systems

produced have
risen from 24,000 to
58,000 and OEMs
are benefiting from
greater economies
of scale

13

Exhibit 18

OVERALL, FACTOR COSTS ARE ACROSS THE BOARD HIGHER IN


MEXICO THAN IN CHINA
Factor cost comparison Mexico
Unskilled

Land

Energy

$ per hour

$/Sq.M manufacturing land


rent

US cents/Kwh ind. electricity

China

0.59

China

India

0.65

Malaysia

37.44

1.47

Taiwan

37.68

Brazil

1.58

Mexico*

Malaysia

1.73

India

Mexico

Taiwan
Korea

5.39

U.S.

6.44

U.S.

Brazil
21.33

Korea

3.76

China

33.00

4.98

U.S.
Mexico

5.40

42.00

Korea

5.55

43.04

Taiwan

5.60

Malaysia

5.63

48.48
78.00

6.07

Brazil

94.53

India

9.28

Mexicos factor costs are


more expensive than
Chinas across the board

* Average land cost in Ciudad Juarez, Chihuahua


Source: Literature searches, EIU, ICBC, Monthly Bulletin of Earnings and Productivity Statistics (China); Taipower, WEFA WMM, DRI WEFA,
Healy & Baker, ILO, Malaysian Ministry of Human Resources, Central Bank of Malaysia, State Economic Development Corporations
(Malaysia), Malaysian Industrial Estates Bhd., Malaysian Statistics of Electrical Supply, Tenaga Nasional (Malaysia), Folha de SP
(Brazil), Aneel (Brazil), Bancomext (Mexico), Expansion (Mexico)

Exhibit 19

APPAREL DIFFERENT COUNTRIES SPECIALIZE IN THE PRODUCTION


OF DIVERSE RETAIL GOODS
Product design
Extremely rapid turnaround
manufacturing (trend-oriented)

Canada

Tailoring/
high-skill
W. Europe

E. Europe

U.S.

Mexico

Product
design

Low-end fashion

China

India

Low-end
fashion/
commodity

Source: Interviews; McKinsey analysis

Commodity

Commodity

14

In IT/BPO, labor-intensive activities are increasingly being offshored to lowercost locations to India particularly, but also to Ireland and Mexico. The
offshored activities range from low-skill data entry and verification activities
(e.g., data-base management) to live customer support services (e.g., call
centers), and increasingly highly skilled activities as well (e.g., customized
software development; Exhibit 20). Depending on the share of the offshored
activities in total production costs, companies can capture cost savings of up
to 50 percent by offshoring.
Horizon 4: Value chain reengineering
Benefits from relocating to a lower-labor-cost location can go far beyond the
savings from lower wage and components costs, which are substantial in and of
themselves (Exhibit 21). Instead of simply relocating the production process
designed for their home country, companies have significant opportunities to
reengineer their production process to take advantage of access to low-cost labor.
Some companies in IT/BPO and auto are already taking advantage of this and
reaping large financial benefits.
In IT/BPO, companies with offshored operations can increase their profits by
50 percent by moving from two to three shifts. This allows them to increase
the total capacity of customers served while increasing efficiency of capital use
as the largest fixed-cost buckets, computers and communications equipment,
are utilized 24 hours a day. In essence, they achieve capital productivity gains
at the expense of labor productivity to reduce total costs (Exhibit 22).
In automotive, global companies in India have adopted some more laborintensive manufacturing methods from their Indian JV partners, mainly by
reducing automation throughout the manufacturing process (e.g., loading and
changing dies in pressing, body welding and material handling, hand painting
cars; Exhibit 23).
Horizon 5: New market creation
The cost-saving opportunities from value-chain disaggregation and reengineering
have the potential of shaving 30 to 50 percent off the total costs for some
companies. The lower cost base creates growth opportunities for companies both
by increasing demand for existing products by moving down the demand curve, as
well as by creating new markets by offering new, cheaper products and services
to customers in both developed and developing countries (Exhibit 24).
A lower cost structure allows companies to expand their markets by offering
existing products to existing and new customer segments at lower prices for
example, U.S. financial institutions have been able to broaden the customer
segments (e.g., customers with smaller accounts) to which it is financially
feasible to provide personalized phone support by using lower cost off-shored
locations. They can also create completely new markets with products that
were not financially feasible at a higher cost structure (e.g., collection of small
accounts receivable that has become economically viable as a result of lower
collection costs from off-shored locations). All of this allows companies to
increase their revenues and capture market share.

15

Exhibit 20

HIGHER VALUE-ADD ACTIVITIES ARE INCREASINGLY BEING


OFFSHORED
Current activity (examples)
Services

Captives

3rd parties

Portfolio analysis (e.g.,

Value-added Knowledge

American Express)

services (e.g.,
EVALUESERVE, Pipal
Research)

Full product design (e.g., Fluor


Daniel, Bechtel)
Knowledgeintensive
activities

Revenue accounting/

Revenue accounting (e.g., Hewitt,

Loyalty program support


(e.g., WNS, Progeon)

Increasing complexity and value

EDS)

Horizontal corporate
center processes

Inward and outward calls, e-

Pre-sales marketing, e-

mail responses (e.g., GE,


American Express)

mail responses (e.g.,


TransWorks,
Spectramind)

Customer contact

End-to-end mortgage and

Basic transcription services


(e.g., Ace Software, Karvy)

loan processing (e.g., HSBC,


Standard Chartered, GE)
Vertical back-office
processes

Basic data entry (e.g.,


Datamatics)

Source: Interviews; press reports; McKinsey Global Institute

Exhibit 21

LOWER LABOR AND COMPONENT COSTS ARE MAKING


EXPORT-ORIENTED ASSEMBLY IN INDIA MORE ATTRACTIVE
Cost of producing a similar model
percent

Lower levels of automation in Body shop,


assembly and material handling and
indigenous automation developed at 1/5th of
international costs drive capital costs down
22-23%

100
13
76

16

Labor
costs in
India 1/8th
of Japan

Cost in
Japan

Lower
labor
costs

1-2

74-75

77-78
3

Component
costs ~40%
lower

Lower
component
costs*

Factor cost savings

Higher
duties on
imported
components
and steel

Production
cost in
India
assuming
identical
capital
intensity

Lower
automation in
assembly
only

Production
Transporcost in India tation
given lower cost **
automation

Landed
cost in
Japan

* 90% of all components sourced indigenously with equivalent or superior quality; savings achieved through lower factor costs and
process reengineering including lower automation
** $300 for a small car; $500 for a large car; no tariffs for imports into Japan from India
Source: McKinsey Global Institute

16

Exhibit 22

REENGINEERING PROCESSES TO OPTIMIZE FOR CAPITAL CAN


IMPROVE MARGINS SUBSTANTIALLY
Process sequence for customer service call center

Potential impact
on vendor profit
margin ~50%

Impact on operating cost


$/billable seat/hour

Process reengineered for


offshore location

Typical
process
sequence

1.60
0.20

Customer calls a service


center requesting an
address update and
additional service
subscription

Customer calls a service


center requesting an
address update and
additional service
subscription
-1.20

Agent accesses customer


account database to
update address and/or
change subscription status
in real-time (15 minutes)

Agent enters customer


request in request tracking
log (10 minutes)
A second agent batchprocesses request by
accessing customer
account database in 2nd or
3rd shift (10 minutes)

Case closed

Impact of
Increase in
transaction
processing
time
(5 minutes)

Impact of
process reengineering
increased
equipment
utilization
(5 minutes)

Penalty
on labor
productivity

Case closed

Impact
of task
reengineering reduced
software
licensing
costs

Improvement
in capital
productivity

Total

Net impact

Source: McKinsey Global Institute

Exhibit 23

MOST INDIAN PLAYERS EMPLOY LOWER LEVELS OF AUTOMATION


Shop

Best practice
level of
automation

Observed
in India

Activities, which
can be automated

Press

90-100

75-90

Loading of presses
Changing of dies

Body

90-100

0-40

Paint

Assembly

Production related
activities

70-80

10-15

15-20

20-60

<1

<1

Share of total
employment*

Welding
Clamping
Material handling

17

Priming
Base and top coat
Sealing
Material handling

14

Windscreen
Seats
Tires
Axles
Etc

33

Material handling
(transport of parts to
the line)

31

Total
* Based on sample of companies covering 93% of total production in 1999-2000
Source: Interviews; McKinsey Automotive Practice

100

17

Exhibit 24

OPPORTUNITY TO DEVELOP NEW MARKETS AFTER GLOBAL COST


OPPORTUNITY CAPTURE
Supply
current

Price

Supply global
opportunity

Demand

Quantity
Significant market growth
opportunity if global cost
opportunities captured

Source: Interviews; McKinsey analysis

18

Companies can also expand the addressable market by customizing product


standards and designs to the needs of the lower income markets in developing
countries. Companies can consider the relative costs and benefits of
standards more relaxed than those now in place in their home countries (which
often were not there just 10 or 20 years ago). Indian auto and Chinese
consumer electronics sectors provide examples of successful execution in
customizing standards. In the Indian auto sector, one OEM has designed lowcost cars with fewer safety tests and material standards, targeting the domestic
market at a fraction of the production costs for similar cars in the triad
(Exhibit 25). In China, local consumer electronics companies have designed
lower-end air conditioners that allow them to offer products to the segments of
the population that were previously not able to afford them.
THREE INTERPLAYING CHARACTERISTICS DETERMINE THE STAGE OF
INDUSTRY RESTRUCTURING IN A SECTOR
The degree of sector globalization can be estimated by global sales, global trade,
or a trade/sales ratio. These measures suggest what most already know, that
consumer electronics is a highly global industry, and that, given massive regulatory
protection in many countries, steel is not (Exhibit 26). However, these measures
do not necessarily correspond to the stage of global industry restructuring. The
interplay of industry characteristics, legal and regulatory restrictions, and
organizational limitations determine the stage of industry restructuring in a sector
(exhibits 27-28)
Industry characteristics include scale economies that make concentrating
production attractive, sensitivity to certain costs such as labor, high bulk-tovalue, or ease of transporting products. These characteristics influence the
ability to relocate operations and the potential for location-specific advantages
(Exhibit 29).
The nature of apparel makes it a prime candidate for industry restructuring
along both dimensions: labor represents the bulk of total production costs
making low-wage locations very attractive, and low transportation costs create
few barriers for relocating further away from final consumers (Exhibit 30). The
business process offshoring (BPO) sector can similarly generate large cost
savings by offshoring very labor-intensive tasks to low-labor-cost locations like
India. Furthermore, the service nature of the sector limits transportation costs
to telecommunications and electronic data transfer only. Steel is a very
different case. In steel, the high investment in capital-intensive production
facilities, the low share of labor in total production costs, and high
transportation costs all reduce the potential benefits from disaggregating and
relocating the global value chain closer to the high-quality raw materials.
Legal and regulatory restrictions include high tariffs, quotas, local content
requirements, and other trade barriers. These, too, tend to make certain
activities necessary and others impossible.

19

Exhibit 25

INDIAN OEMs HAVE SUCCEEDED BY DEVELOPING


LOCALIZED PRODUCTS AT A FRACTION OF GLOBAL COSTS
Product development costs for a SUV
$ Millions
~725
170
110
n/a
50
75
10
11
10
8
20
25

320

84

Cost of
developing
Scorpio

Product development cost for car


$ Millions

Prototype
and testing
1,200-1,500

Personnel and
consultant costs
Model variants
Assembly line and
plant improvements
Vendor tooling

~550

Dies

Cost of
developing
similar SUV
in the U.S.

Cost developing
Indica

Cost of
producing similar
car in the U.S.

Note: These comparisons are rough estimates collected through interviews and are illustrative only. While the
products being compared are similar, significant differences in regulatory standards, features, and quality exist
and may not provide an apples-to-apples comparison
Source: Literature searches; interviews; McKinsey Automotive Practice; McKinsey Global Institute

Exhibit 26

MEASURES OF GLOBAL INDUSTRY RESTRUCTURING 2000

Global trade
$ Billions

Global sales
$ Billions
Consumer
electronics

640.5

IT/BPO*

118

496

77

500

1,200

Auto
Steel

650

550

Apparel

Trade/sales ratio
Percent

42

81

249
3,000

32

* IT/BPO sales figure includes all IT/BPO exchanges


Source: UN PCTAS database; IISI, Statistical Year Book 2000; DATAMONITOR

33
1

20

Exhibit 27

DETERMINANTS OF GLOBAL INDUSTRY STRUCTURE/CAPTURE OF


OPPORTUNITIES

Ind
ch ust
ar ry
ac
ter
is t

Relocation
sensitivity
Potential for
location-specific
advantages

y
or
lat s
u
eg tic
l/ r ris
ga cte
e
L ara
ch

ics

requirements

Trade barriers
Government

Global industry
structure

incentives

FDI barriers
Other legal/

Firm-level
Organizational
characteristics

Local content

regulatory
characteristics
that affect
market size

incentives/
structures
Union contracts

Exhibit 28

SUMMARY OF ABILITY TO CAPTURE GLOBAL PRODUCTION


AND SALES OPPORTUNITIES
Industry
characteristics
Steel

High sunk costs


Transportation can be

Legal/regulatory
characteristics

Very high tariffs

Organizational
characteristics

Unions play
strong role

expensive
Auto

Some parts more


difficult than others to
source globally

Formal and
informal trade
barriers

Unions
complicate

Organizations more
local/regional
than global

Labor intensive
Easy to ship

High trade barriers,

Unions are

though regional
agreements help

not very
powerful

Consumer
electronics

Most products easy to

Trade barriers

transport, though
obsolescence an
issue in some cases

generally low

IT/BPO

Easy to transport,

Apparel

though breaking off


portion of value chain
more difficult in some
segments

Source: Interviews; McKinsey analysis

No trade barriers
currently

Global
production
networks
incentivized

Often no
incentives in
place to
offshore

Favors global
production/sales
Inhibits global
production/sales
Overall rating

U.S. trade
barriers;
environment

More
opportunities
appear to be
available

Trade barriers
prevent further
restructuring

High degree of
opportunity
capture

Nascent
opportunity will
will develop
quickly with
more
organizational
incentives

21

Exhibit 29

How feasible is it to relocate components globally?

INDUSTRY CHARACTERISTICS INFLUENCING LEVEL OF PRODUCTION


DISAGGREGATION
High

Relocation
sensitivity

Home market
Large auto body
stampings
Fast-fashion
retailers*

Border zone/home
market
Refrigerators
Fashion apparel
Finished passenger
cars
Flat downstream steel

Indifferent
Long steel
products

Specialization zone
Specialist zone
Commodity
apparel
Commodity apparel
Semiconductors
Semiconductors
Wiring
harness
Wiring harness
Flat
upstream steel
A

Low
Low

High
Potential for locationspecific advantages
What are the benefits of relocating components globally?

* Companies that focus on selling trendy clothes that go out of style within 1-3 months (e.g., Zara, H&M); they
are not high-end luxury companies (e.g., Ralph Lauren)

Exhibit 30

MANUFACTURING LOCATION BECOMES A PRIMARY DIFFERENTIATING


FACTORY IN TOTAL PRODUCTION COST IN APPAREL
FOB cost breakup of a shirt
Percent
100% =
$8.55
($ Millions)
Profit

12%

Sales/G&A

Other manufacturing
expenses

22

5.45
14
6

Labor cost in apparel


manufacturing

22

37

5.71
13
7

5.42
4.91
14
7

32
40

14
7
34

Labor cost in fabric

11
2

10
10

4 1

Raw material

19

30

28

34

32

U.S.

Mexico

U.S./Mexico

India

Thailand

10

Source: Competitiveness and globalization: The international challenge by Raoul Verret; Apparel Industry, September 1997

22

Import quotas and tariffs on apparel have reduced the extent to which global
production has been restructured and optimized across regions. The protection
of production on specific locations end users countries through tariffs or
specific production locations through quotas means that despite the
economic case for production in lowest wage environments, the global apparel
industry cost structure remains above its potential. Similarly in steel, the
regulatory environment (both tariffs and regulated clean-up costs) has further
limited the incentives for companies to relocate production to a lower-cost
environment. In contrast, the newly emerging IT/BPO sector has not been
subject to trade barriers, so companies are free to take advantage of the costsaving opportunities. The Indian government has also waved most taxes for
IT/BPO to encourage investment (Exhibit 31).
Organizational limitations include firm level incentives or union contracts.
Changing organizations to operate differently is a major challenge. Proof that
this is difficult can be seen in the resistance of many U.S. and European based
managers to take advantage of offshoring cost-saving opportunities because
the job losses they would cause to their home organizations; and in
automotive, OEMs buckled to strong unions' demands in U.S. and kept
production local rather than moving more aggressively to low-cost production
sites like Mexico (Exhibit 32).
The critical interplay of the characteristics is illustrated well when comparing
consumer electronics and automotive sectors.
Consumer electronics is among the sectors furthest along in the process of
global industry restructuring. (Exhibit 33). There are several reasons for this:
transportation is relatively easy and low-cost relative to value; large
economies of scale may be exploited, particularly in parts; and, perhaps
most importantly, few policy barriers or organizational factors stand in the
way of global restructuring for consumer electronics companies. The liberal
market environment has, in fact, created a very competitive sector globally,
where successful companies are forced to innovate rapidly and aggressively
reduce costs. This has led to a globally disaggregated, specialized, and lowcost value chain, and consumers have seen huge improvements in product
quality at the same time as prices are constantly declining.
Auto assembly has a more complex product (measured by number of parts
incorporated into the final product), and higher transportation costs because
of the bulkiness of the parts, reducing the cost-saving potential from
industry restructuring relative to consumer electronics. But just as important
have been the policy and organizational barriers that have kept the sector
from moving beyond the first stage with few regional exceptions. The
automotive sector has import barriers and tariffs in many developing
countries, and the highest levels of direct government incentives for locating
production within the end-user economies. At the same time, strong unions
in developed countries limit the push for seeking for alternative production
locations. All these factors have inhibited companies from aggressively
seeking opportunities for reducing costs through industry restructuring, and
they have also kept the product value chain tightly controlled by the OEMs
(i.e., mostly proprietary parts with little standardization; close supplier-OEM
relationships that limit value-chain disaggregation). One could argue that

23

Exhibit 31

TRADE BARRIERS IMPORT TARIFFS, 2003

High tariff segments

Percent

Auto
Finished goods
Passenger cars
Components

Motherboards
TV tubes

*
**
***
Source:

38.2
10.0
18.0

17.5
21.5
19.5
19.5

Consumer electronics
Finished goods
TVs
PCS
Refrigerators
Intermediate goods
Semiconductors
0

Apparel
Mens shirts
Cotton bras
Denim jeans
Steel
Forged bars/rods
Flat iron coils (cold)
Flat iron coils (hot)

Germany*

35.0

Wiring harnesses
Car radios
Body stampings
Radiators

IT/BPO

China

Brazil

21.5
24.0
21.5

16.0
19.5
0

35.7
18.8

33.0
0
0

15.0

12.0
12.0
12.0

14.0
0
1.9-2.5
0
0

30.0

0
0
0

30.0

30.0

14.0

12.0
6.5
12.2
0.5
23.9
23.9

30
18
18

30

30.0**
30.0**
30.0**
40.0
40.0
40.0

23

5.4
5.7
5.8
4.7

5.0

8.6
1.1
3.3

0
0

0
0.8

0
18

0
35
35
35

7.4***
8.4***
9.1
18
13
13

12.2

15.0

0***
0***
0***

9.1

5.0
3.7
2.5
2.5

0
0

2.5

13

0
0

Weighting
to GDP

U.S.

20

0
15.0

7.0
6.0
6.0

0
0
0
0

15.0

Mexico

30.0
30.0
30.0
30.0

12.0

17.7
19.5
18.5

105.0

3.7
2.0
3.0
3.0

20.0
20.0
20.0

Japan

10.0

India

19.8
17.0
16.7
30.0
30.0
29.0

17.1
15.3
15.8
18.7
20.9
20.4

U.S. to Germany; representative of non-EU tariff schedule


Or Rs.135 per piece for mens shirts and jeans; or Rs.30 per piece for cotton bras
WTO tariff; general tariff for mens shirts: 9.0%; cotton bras: 8.5%; denim jeans: 11.2%; steel (all categories): 3.9%
WTO; EU trade database; TecWin Brazil; Banco Nacional de Comercio Exterior, S.N.C.; Customs Tariff Schedules of Japan, China, U.S., and India

Exhibit 32

ORGANIZATIONAL BARRIERS TO GLOBAL INDUSTRY


RESTRUCTURING AUTO AND IT/BPO

Auto

IT/BPO

Source: Interviews

Barriers

Impact/example

Strong labor unions in U.S.

DaimlerChrysler had 2 plants producing


Dodge Rams, 1 in Mexico and 1 in the
States (St. Louis). The company needed
to shut down one plant because of overcapacity. Although the Mexican plant
made better quality vehicles, DaimlerChrysler decided to shut down the plant
in Mexico because of concerns regarding
the U.S. labor union reaction

Little incentive to tweak

Due to agency problems/perceived high

template in new markets


Most mid-level managers resist
off-shoring despite the value
created for the company
because the disadvantages
are disproportionately borne by
a few (i.e., loss of jobs;
reduced managerial sphere of
influence)

risk, replicate operators/capital structures


and focus on market growth instead of
focusing on opportunities to trade labor
for capital in emerging markets
Slower migration of outsourcing work to
offshore locations

24

Exhibit 33

ROLES COUNTRIES PLAY IN GLOBAL VALUE CHAIN CONSUMER


ELECTRONICS EXAMPLE

Demand
market
production
Systems
integration

Specialist
production
Mouse and
keyboards
Specialist
production
DRAM
production
Specialist
production
Semiconductor
design/production

Specialist
production
MPU design
fabrication

Demand
market
production

Border
zones
production

Border zones
production
Desktop final
assembly

Perform tasks where


good/service cannot
be effectively sourced
outside demand
market due to
Industry, policy or
organizational factors

Perform production
for goods where
transportation
sensitivity outweighs
advantages
presented by
specialist production
zones

Produces goods at
Specialist
production

lowest possible cost


by capturing low labor
costs, economies of
scale/scope and/or
natural resource cost
advantages

Source: Interviews

Exhibit 34

SUMMARY OF EXPORT COMPETITIVENESS


Advantage

Description

China has a more developed supply chain across all electronic


industries

Unit manufacturing costs

Input Costs

Sources of cost advantage in inputs are logistics and factor costs


Mexico loses competitiveness on items it must import from the
U.S. (e.g., TV glass)

Productivity at very similar levels per both estimates and expert


Productivity

<=

interviews

China offers distinct cost advantages in labor (skilled and

Factor costs

unskilled), electricity and land costs

Mexicos geographic proximity to the U.S. as well as similar time


zone lower interaction costs with the U.S.

Other costs

Interaction costs

This is especially important for newer and customized products


Border zones provide shipping advantage
However, the geographical location advantage is far from being

Transport costs

maximized

Furthermore, component logistics increase costs for Mexico


Mexico has tariff advantage (e.g., TVs) or parity (e.g., computers)

Tariffs
=>

Taxes

with China

This advantage is shrinking with Chinas accession to WTO


Income taxes on manufacturing is much lower in China than in
Mexico

25

the auto assembly sector today is at a stage where the PC industry was in
the 1980s, when IBM controlled the full value chain from semiconductors
to software. Despite the differences in the two sectors, however, removing
some of the policy and organizational barriers to auto sector restructuring
would be likely to lead to significant change.
PRESSURE TOWARDS INCREASING SPECIALIZATION FOR COUNTRIES AND
COMPANIES
Many of these seemingly "immutable" characteristics are now undergoing major
change as a result of competition, liberalization, and new technologies, opening
up new possibilities. The changes are leading to increased specialization of
production around the world, with countries and companies playing specific roles
in the global production value chain.
With global industry restructuring, we will see increasing specialization of global
production between countries and regions along the lines of comparative
advantage. With the move from product specialization to increasing valuechain disaggregation, specialization in the future is likely to occur more by the
type of activity rather than by specific products or clusters. We are already
seeing the emergence of a number of different patterns of specialization, and
expect the process to continue evolving in this direction. For example, we have
seen Mexico and Eastern Europe emerge as "border regions" that have
industries specializing in assembly and production for a broad range of
products and services destined for U.S. and Western Europe, the world's two
largest end-user markets. Mexico's proximity to the U.S. market and the tariff
benefits from NAFTA allow it to be a leading consumer electronics supplier to
the U.S., despite having higher labor costs than Asian locations. China's
comparative advantage is its large pool of very-low-cost labor, and it has
become the global base for low-cost manufacturing of a broad range of lowcost consumer goods (from clothing to toys and bicycles; Exhibit 34). The U.S.
is leading the transition of developed economies away from manufacturing, as
first consumer electronics production, and now, more slowly, auto parts
production, is moving cross-border.
This trend is causing countries to adopt different roles in the global production
chain. In apparel for example, three large apparel export players, Eastern
Europe, Mexico, and India, have standalone local supply chains behind their
exports. China, on the other hand, plays the role of an intermediate broker, by
both importing and exporting large volumes of cloth. Among developed
economies, Japan and the U.S. are purely importers, while Western Europe is
closely integrated into the global supply chain, as it both imports and exports
large volumes of final goods. Lastly, Brazil remains largely isolated from the
global economy, with low imports and exports of both inputs and final goods
largely because of very high barriers to trade (Exhibit 35). A similar story can
be told of the different roles in consumer electronics (Exhibit 36).

26

Exhibit 35

DIFFERENT ROLES OF COUNTRIES IN GLOBAL APPAREL TRADE

Input trade

Finished goods

High Exporter

High

Processor/trader
W. Europe
China

Exports

Final goods
exporter/
processor
China
E. Europe
Mexico
India

Finished goods
specialized
producer/trader
W. Europe

Standalone final
goods producer
Brazil

Final goods
importer
U.S.
Japan

Exports

Low

Standalone
component
Brazil
Japan
E. Europe
U.S.
Mexico
India

Importer

Low

Low

High

Low

Imports

High
Imports

Source: McKinsey analysis

Exhibit 36

COUNTRIES ROLE IN GLOBAL CONSUMER ELECTRONICS PRODUCTION


AND CONSUMPTION CAN BE SEGMENTED INTO PATTERNS
Input trade

High

Finished goods

Technology
exporter
Japan
Korea

Technology
processor/trader
ASEAN
US

Technology
stand-alone

Technology
importer
China
Mexico
Brazil
E. Europe
Australia/NZ
W. Europe

Exports

Final goods
exporter/
processor
China
High ASEAN
Mexico
Korea

Finished goods
specialized
producer/trader
Japan
E. Europe

Exports

Low
Low

Low

High
Imports

Source: McKinsey analysis

Stand-alone final
goods producer
Brazil

Final goods
importer
US
W. Europe
India
Australia/NZ

Low

High
Imports

27

As companies take advantage of the opportunities provided by the new


changes, they are also increasingly finding ways to focus on the steps of the
value chain where they have a competitive advantage. Hence we will see
companies that are innovators and designers, low-cost producers, specialized
border producers, marketers and distributors, among others. Conversely, there
will be fewer generalists, those that can excel at all the increasingly specialized
steps of the value chain (Exhibit 37).
***
The global opportunity landscape for companies is changing. Policy and
communications barriers to integrating developing countries into the global
economy are declining. This creates new opportunities for radically reducing costs
to seek new demand by moving along the five horizons of industry restructuring:
from market entry and product specialization through value chain disaggregation
and reengineering to new market creation.

28

Exhibit 37

PARTICIPANTS IN DISAGGREGATED OR VALUE CHAIN

Innovators
and
designers
Marketers/
distribution
Capitalintensive
specialists
Process
managers
Border
zones
Low labor
costprocesses

Role in value chain


Make fundamental breakthrough
through R&Ds
Design new products to better
meet consumer demand

Examples
Sony (Japan)

Control brand and distribution

HP (U.S.)

channels in home market

Specialize and build scale in

TSMC (Taiwan)

capital intensive facet of


production

Manage production for global


branded companies as
intermediary

Exploit geographic proximity to


large end markets and labor
cost advantage

Play strong role in laborintensive/commodity production

Contract
manufacturers
(Taiwan, Singapore)

Maquiladoras/
Mexico

Contract
manufacturers
(China, Hong Kong)

High
Medium
Low

Value add

Implications for
Companies
The opportunities opening up from global industry restructuring can lead to
massive value creation for bold companies. But capturing the opportunities will
not come easily: success in global industry restructuring will be based on good
strategy and execution against new tradeoffs in new market environments.
MASSIVE VALUE CREATION POTENTIAL FROM RESTRUCTURING
The changing global landscape creates enormous opportunities for cost
savings and revenue generation. In the auto sector example, over $150
billion in cost savings and at least another $170 billion of revenue could
result if the barriers to industry restructuring could be overcome. Together
these two opportunities represent roughly 27 percent of the $1.2 trillion
industry.1 Capturing even part of this represents a huge value-creation
opportunity for those companies that pursue it, and a competitive risk for those
companies that do not.
Each of the five horizons of industry restructuring offer potential cost savings
and additional revenue generation potential. We assessed and estimated each
separately (exhibits 1-3).
Increasing specialization of production and intra-industry trade, enabling
capacity utilization to increase by 20 percent, would generate more than
$10 billion in total savings.
Increasing value-chain disaggregation would allow companies to gain
economies of scale and scope, as well as reduce production costs. Shifting
up to 70 percent of total production costs (including parts) to low-labor-cost
developing countries, could result in nearly a $148 billion opportunity in
total savings. Additional opportunities from value chain reengineering could
add tens of billions in further savings.
Finally, companies could generate additional revenues by taking advantage
of these cost savings to introduce lower-cost cars to specific regions and
market segments in essence, creating new markets. Some $100 billion
in developing markets and more than $70 billion in developed markets is
possible.
Companies that shape their industry evolution will need to size the
opportunities from each of the five horizons and be able to understand which
of the existing constraints to sector restructuring are subject to change. This
requires a disciplined three-step approach: first, to identify the relevant
components of each of the three types of factors nature of industry, policy
and organizational environment that affect the stage of industry restructuring.
Second, to assess which of the factors are mutable through changes in
technology, management, or policy changes. And third, to estimate the
specific returns attainable from each change. This is the process we followed
1.

We have not explicitly included capital in the sizing estimates because optimal capital
deployment decisions need to be closely tied to the location and reengineering decision and
as a result, are likely to vary even more widely going forward. However, the sheer size of the
opportunity suggests that significant capital outlays are justified. Similarly transportation and
logistics would consume only a small share of the opportunity. For both cars and parts
shipping costs and times are falling: shipping an automobile anywhere in the world today costs
only $500 and takes 3 weeks.

29

30

Exhibit 1

POTENTIAL FUTURE PATHS FOR THE AUTO SECTOR PART 1


2 Better utilize existing capacity
Product specialization
Auto: U.S.- Mexico

Chevrolet TrailBlazer
(Dayton, OH)

e
ad
Tr

Potential savings
of $10 billion+
Pontiac Aztek
Ramos Arizpe, Mexico

Shift production to LLC zones

Value chain disaggregation/reengineering


Auto: US to China
Percent

IBM

U.S.

30

LCC

70

Potential
savings of
$148 billion

U.S.
Demand

China/India
production

Exhibit 2

POTENTIAL FUTURE PATHS FOR THE AUTO SECTOR PART 1


(CONTINUED)
4

Alter production technology


Disaggregation

Factors promoting and hindering disaggregation


Hindering

Promoting

Brand differentiation plans may

Pooling demand permits

insist on non-standardized parts

investment in new
methods
Supplier concentration
allows OEMs to drive part
standardization, thereby
cutting costs
Concentrating demand in
specialists accelerates
learning curve effects

Short-order-cycle customization
strategy would require sitting parts
plants near car plant
Sourcing strategy may block
dependence on a very small
number of suppliers
Technological innovation may fall to
yield new scale economy curves

Disaggregation of value
chain would allow
individual entities to
accumulate enough
scale and scope to
permit altering the
technology of
production, enabling
shifts to new scale
economy curves* if
conditions are right

Savings could be tens of billion $ but depends on company specific strategies vis-vis product customization, supplier dependency, brand differentiation, etc.
* E.g., sufficiently high volume of wiring harnesses concentrated in one location and entity might permit investment
of capital to automate what is now a wholly manual process

31

Exhibit 3

POTENTIAL FUTURE PATHS FOR THE AUTO SECTOR PART 1 (CONTINUED)


5

Lower cost model taps new markets

Price/unit

Potential for
$170+ billion
revenue
opportunity

$10,500

Demand (2007) in
developing countries

$7,350

0
0

38.9
22.2

Quantity (millions)

Total potential cost


savings/revenue
opportunity more than
27% of $1.2 trillion sales
(+$328 billion)

32

through for the auto sector to assess the global value creation potential
(exhibits 4-7).
Companies that identify the barriers that can be relaxed and find ways to
remove them are likely to capture disproportional share of the value. A good
example of mutable barriers is the level of standardization in the sector: while
it is often seen as a given, it is often more closely related to economic policies
and ingrained industry practices than to the nature of the industry itself. Again,
the consumer electronics and automotive sectors provide a good contrast: in
consumer electronics, the high level of standardization is the result of the
competitive industry dynamics (often a voluntary action by a group of
companies to abide by a given standard as part of their competitive strategy)
and in some cases, regulation (as in wireless handset standards set by
governments). In auto, there simply has been no regulation or competitive
pressure to increase standardization in select auto parts although there may
well be large opportunities in, say, windshield wipers and headlights. We believe
that with the declining rate of trade barriers, some players will find ways to
increase standardization.
SUCCESS ON THE BASIS OF GOOD STRATEGY AND EXECUTION AGAINST
NEW TRADE-OFFS
Success in global industry restructuring will be based on good strategy and
execution against a new set of tradeoffs. Incremental performance mandates will
be increasingly inappropriate as bold targets come within reach. Finding the
optimal capital versus labor mix in production, balancing appropriately global
capabilities with local knowledge of markets, and shifting from multi-locale to
global management will be some of the key new challenges facing companies.
Higher performance imperative
The opportunities for global industry restructuring suggest that the traditional,
incremental targets for performance improvement will be replaced by much higher
performance expectations, first by leaders in the industry, and later by the
competitive pressure to keep up with those leaders.
No single blueprint and each battle is a new one
Growth through global expansion has been shown to be very risky in most
sectors, and no company whether seeking markets or lower factor costs
has a template for operating successfully in all developing markets. Yet for
those few that succeed, the returns are very high.
Global expansion alone does not ensure success there is no direct correlation
between the share of international sales and total returns to shareholders.
Interestingly though, we do see a higher correlation among consumer
electronics companies the furthest along in industry restructuring than
among food retail and automotive, suggesting that the benefits from
globalization are related to the stage of industry restructuring (exhibits 8-10).

33

Exhibit 4

THREE STEP PROCESS FOR EVALUATING BENEFITS FROM


GLOBAL INDUSTRY RESTRUCTURING
Assess sector against
characteristics

Actions

Catalogue all finished


goods and components
used for production
(e.g., passenger car,
wiring harnesses)

Determine
mutability of
characteristics

Determine which
characteristics that
currently inhibit global
sourcing can be
removed

Calculate
returns

Identify areas where


company can take
better advantage of
global sourcing
opportunities
Calculate gains created
by:
Better utilizing
existing capacity
Shifting production to
low labor cost
countries
Altering production
technology
Offering new products
at lower price point to
tap new market

Evaluate each item


against all industry,
legal/regulatory and
organizational
characteristics to
determine
responsiveness to
global sourcing (i.e.,
whether bulk/value ratio
favors or inhibits global
sourcing)
Source: McKinsey Global Institute

Exhibit 5

INDUSTRY CHARACTERISTICS: RELOCATION SENSITIVITY


Low - Favors global sourcing
High - Inhibits global sourcing

Bulk/value

Ease of
meeting
quality
standards

Obsolescence time

Damage
sensitivity

Auto parts

Wiring

Compressible

harnesses

Car radios

Special
packaging

Major body

Shipping air,
special
packaging

stampings

Radiators

Stackable,
needs
protection

Source: Interviews; McKinsey analysis

Manual
testing

Components
easily shipped
to assembly
point

Driven by
fit at
welding
shop

Could be
damaged
or scratched
in transit

Shipping
damage risk
high

Demand
volatility

Sunk
costs

Overall
relocation
sensitivity

34

Exhibit 6

INDUSTRY CHARACTERISTICS: LOCATION-SPECIFIC


ADVANTAGES

Favors global sourcing


Not a factor in sourcing
production locations
Key characteristics

Labor cost
sensitivity

Economies of
scale/scope

Natural
resource
intensity

Skill
intensity

Auto parts

Wiring
harnesses

Car radio
Major body
stampings

Radiators

Source: Interviews; McKinsey analysis

Exhibit 7

GLOBAL INDUSTRY RESTRUCTURING ASSESSMENT TOOL:


Low - Favors global sourcing
WIRING HARNESSES
High - Inhibits global sourcing
Area of opportunity
Industry
characteristics
(location-specific)

Legal/regulatory
characteristics*

Organizational
characteristic*

Labor cost sensitivity

Local content requirements

Firm level incentives

Ease of meeting quality


standards

Economies of scale/scope

Trade barriers

Union contracts

Obsolescence time

Natural resource intensity

Government incentives

Damage sensitivity

Skill intensity

FDI barriers

Overall rating

Overall rating

Industry
characteristics
(relocation sensitivity)
Bulk/value

Demand volatility

Sunk costs

Overall rating

Overall rating

* In light of current legal/regulatory and union environment (i.e., full black circle designates lack of significiant trade barriers)
Source: McKinsey Global Institute

35

Exhibit 8

THERE SEEMS TO BE HARDLY ANY CORRELATION BETWEEN


GLOBALIZATION AND RETURNS TO SHAREHOLDERS IN RETAIL
International sales as a percentage of total vs. TRS-CAGR* for selected Food Retail firms
Percent
TRS-CAGR*
Percent

25
Target
Safeway

20

Wal-Mart
Carrefour

Costco

15

Level of globalization and

Kroger

10
Ahold

-5

Metro

Albertson's

0
0

10

20

30

40

50

60

70

80

-10
-15
-20

Kmart

performance hardly display


any correlation but there
may be many other factors
driving the trend
Wal-Mart seems to be
performing well despite less
than 20% global revenues in
its total revenues. Carrefour
which has over 60% global
revenues in its total
revenues, is also a high
performer in terms of
revenues

-25
International sales
as a percent of total

* Total Return to Shareholders CAGR over period Nov. 1, 1990 till Nov. 1, 2002
Source: Datastream; Bloomberg; company financials; McKinsey analysis

Exhibit 9

LITTLE DIRECT CORRELATION BETWEEN LEVEL OF GLOBALIZATION


AND TRS IN AUTO
International sales as a percentage of total vs. TRS-CAGR* for selected Auto firms
Percent
TRS-CAGR*
Percent
25

Porsche

20

BMW

15

Honda

PSA

Ford

10

Suzuki
Renault
Nissan

5
0

Toyota

GM
Volkswagen

Nissan

Hyundai

-5
-10

Fiat
Daimler Chrysler**

-15
-20
0

10

20

30

40

50

60
70
80
International sales
as a percent of total

* Total Return to Shareholders CAGR over period Nov. 1, 1990 till Nov. 1, 2002
** Sales in North America considered domestic
Source: Datastream; Bloomberg; company financials; McKinsey analysis

Level of globalization and


performance are somewhat
correlated but there may be
other causal factors driving
the trend
Generally companies that
have international sales
accounting for more than
40% of total sales have
shown the best performance
over time

36

Exhibit 10

HIGHLY GLOBALIZED PLAYERS HAVE SOMEWHAT HIGHER RETURNS


TO SHAREHOLDERS IN CONSUMER ELECTRONICS
International sales as a percentage of total vs. TRS-CAGR* for selected CE firms
Percent
TRS-CAGR*
Percent
70
60

Dell

50

Nokia

Level of globalization and


performance are somewhat
correlated but there may be
other causal factors driving
the trend
Generally companies that
have international sales
accounting for more than
40% of total sales have
shown the best performance
over time

40
30

Samsung
HP
Electrolux
IBM
Whirlpool
Siemens
Sony
Sharp
Acer
Motorola
Fujitsu Sanyo Matsushita
Pioneer
NEC
Alcatel
Toshiba
NEC

20
10
0
-10

Philips

-20
0

20

40

60

80
100
International sales
as a percent of total

* Total Return to Shareholders CAGR over period Nov. 1, 1990 till Nov. 1, 2002
Source: Datastream; Bloomberg; company financials; McKinsey analysis

Exhibit 11

COMPARISON OF PROFITABILITY DOMESTIC VS. FOREIGN OPERATIONS


Wal-Mart*
EBITA margin
8

Domestic
Foreign

Significantly stronger
domestic business vs.
foreign, although foreign has
rebounded in recent years

4
0
Carrefour
EBIT margin
8

Downturn in domestic market


margins while international
business has improved

4
0
Ahold**
EBIT margin
8
4
0
1997

Similar returns in foreign and


domestic operations
1998

1999

2000

2001

2002***

* Excludes distribution business, which represents 5% of Wal-Marts total business


** Ahold margins for 1999-2002 represent breakout of Europe vs. non-Europe due to unavailable data on home market, the Netherlands
*** Ahold results for 2002 misstated in financial reports
Source: Annual reports

37

Food retail is an industry where global players have rapidly expanded abroad
during the past 10 years, yet leading players have traditionally generated lower
returns on their international operations than in their home markets
(Exhibit 11). Leading global players have used very different approaches to
global expansion Carrefour expanding through green field operations in
hypermarket format, while Wal-Mart prefers acquisitions and being more
flexible in formats. However, the success of either strategy critically depends
on the local market conditions that influence the options available for them and
the likelihood of success as is suggested by the contrasting experiences of
Wal-Mart in Mexico and Brazil (exhibits 12-14).
In all investments in developing countries, macroeconomic instability and
exchange rate risks remain significant factors that can materially alter market
prospects or cost structure relatively rapidly. The highly volatile macroeconomic
environment in Brazil, and the sensitivity of efficiency-seeking FDI to changes
in exchange rates illustrate this well.
Optimistic growth expectations for the Brazilian economy attracted large
volumes of market-seeking foreign investments in the 1990s
approximately US $100 billion in total. Yet the very volatile macroeconomic
environment (after the end of hyperinflation, recession followed by
devaluation) rapidly changed the domestic market prospects. The example
of auto OEMs investing in Brazil illustrates this: while they expanded
production to meet expected rapid sales growth, realized sales declined by
36 percent between 1997 and 1999 and led to capacity utilization rates
of 51-55 percent (exhibits 15 and 16). Other sectors of the economy were
also heavily affected by the downturn.
In our sample, all countries experienced significant changes in real exchange
rate during the 1990s, and as a result, the relative long-term
competitiveness of efficiency-seeking investments changed. Mexico's
experience is illustrative: steep devaluation in 1995 helped boost rapid
efficiency-seeking FDI inflow, yet slow real appreciation relative to the U.S.
dollar during the rest of the decade eroded Mexico's relative cost position.
And while Chinese currency was fixed to U.S. dollar during the 1990s, it
appreciated in real terms relative to the Yen and Euro. Any exchange rate
changes now would have an immediate impact on the global cost advantage
of Chinese consumer electronics products that we have measured in our
cases.
Finding the optimal capital-labor mix
Companies need to aggressively seek opportunities to further lower cost by
substituting labor for capital or reengineer production. In auto China for
example, European OEMs have put in place capital-intensive plants designed for
European factor costs and as a result, capital intensity in Chinese auto plants
today is comparable to European levels (Exhibit 17). Under intense competitive
pressure, Indian auto OEMs have been driven to a different approach: by reducing
automation across both the production and design process, they have been able
to bring to market significantly less expensive passenger cars than are available
from the stables of the global OEMs. And the IT/BPO case illustrates the large

38

Exhibit 12

WAL-MART ENTERED FIRST TO MEXICO AND THEN TO BRAZIL

1990

1991

1992

1991

50/50 JV with
Cifra, a leading
domestic
retailer, to open
2 discount
stores

Mxico

1993

1994

1995

1996

1992

1997

1998

1999

2000

2001

2002

1997

Cifra JV

Wal-Mart acquires

expanded to
include more
store and
formats, with
explicit option for
taking control
later on

majority ownership
of Cifra with $1.2
billion

1995

60/40 JV with
Lojas Americanas
to acquire local
knowledge (5
stores)

Brazil

1997

JV is
dissolved

Continued slow
organic growth to
reach 22 stores

Source: Interviews

Exhibit 13

WAL-MART WAS VERY SUCCESSFUL IN MEXICO


. . . and gained market share of
modern retail market
Total sales in Mexican pesos of 2001

In Mexico, Wal-Mart has rapidly increased


productivity . . .
Mexican pesos of 2001 per hour worked

100% =
Wal-Mart

1996

1996

204

1.9%
CAGR

2001

Other
modern
sector*

150

92

100

Other
modern
sector*

80

Wal Mart

20

73

78
-1.9%
CAGR

2001

70

1996

27
2001

Key to Wal-Marts strong performance was early


entry and successful JV partnership, acquisition,
and integration of a leading domestic retailer
* Includes self service formats (hyper-and supermarkets and convenience stores) that represent 30% of total Mexican
food retail market
Source: McKinsey analysis

39

Exhibit 14

WHILE IN BRAZIL, WAL-MART HAS THE LOWEST MARKET SHARE OF


ALL FOREIGN PLAYERS
Wal-Mart entered without a strong

2001 R$ billions; percent


100% =

57.8

local partner in Brazil which was the


key differentiating factor to their
performance in Mexico. This decision
was due to
Lack of an available appropriate
target
Decision to adopt a cautious entry
strategy focusing less on market
share gains and more on
performance of existing investments

72.5

Other
59
75

Wal-Mart
2
4
5
3
3
1
10
8

1996

Casas
Sendas
Bomprec/
Ahold

Lack of a strong domestic partner had


many negative effects:
It slowed Wal-Marts ability to benefit
from scale (e.g., low purchasing
power)
It has made it slow to adopt their
skills to local market (e.g., difficulty
with tailoring assortment to the local
market)

Sonae

13

Carrefour

14

CBD

2001

* Includes only formal modern retailers


Source: McKinsey analysis; ABRAS

Exhibit 15

AUTOMOTIVE SALES IN BRAZIL*


Thousand units

1,943
70

Plano Real

1,728 1,731
57
76

1,396
65
1,132 203
Truck/bus
50
178
LCV

245

1,535
70
253

1,407 1,406

Passenger
car

303

268

1,257
61
184

1,212
1,012

904

1994

1,489
85

1995

1996

1,588
90
216

227

1,488
83
175

3.1
5.8
-0.2

1,570

1,128

1993

CAGR
1993-2002
Percent

Sales fell by 36%


from 1997-99*

1997

1998

1999

1,177

1,295 1,230

2000

2001

3.5

2002

* Compare this to the biggest drop in the U.S. of 32% over 1978-82; biggest 2-year drop was 24%
Note: Figures include total domestic sales (including imports)
Source: Anfavea

Demand crashed
due to high interest
rates, a general
recession in 1998
and a large
devaluation in
1999. It has yet to
fully recover to
mid-1990s levels

40

Exhibit 16

PRODUCTION AND EXCESS CAPACITY OF LIGHT VEHICLES, 1994-2001


Thousand vehicles per year
3,000

3,100

2,750

Holding capacity
constant at 2002
levels, utilization
would reach the
worldwide
average of 75%:

2,500
2,300

Total capacity
Excess capacity

1,399

1,173
799

1,213

263

200

By 2009 if

1,738

1,537

Actual production 1,500

Utilization
Percent

1,900
162

1,800

1,700

1,283

2,125
141

average
production
growth is 5%
(optimistic case)

1,984
1,597

1,501

1,717

1,701

1,287

By 2013 if

1994

1995

1996

1997

1998

1999

2000

2001

2002

88

75

91

93

65

51

57

57

55

average
production
growth is 3%
(realistic case)*

Worldwide industry
utilization estimated
to be 70-75%

Note: Exports are usually 20-24% of production (only 16% in 1995-1996). Capacity figures reported are for end of year.
Total capacity numbers are rough estimates, and depend on each OEMs assumptions about shift lengths, etc.
* Realistic case is based on average sales growth figures for 1993-2002. Optimistic case assumes 2% additional
growth, due to domestic market recovery and/or increasing exports
Source: Anfavea; CSM Worldwide; Lafis; Just-auto.com; McKinsey analysis

Exhibit 17

CHINESE PLANTS ARE JUST AS CAPITAL INTENSIVE AS U.S. PLANTS


Investment per unit/capacity
US$
4,500

China JV
US
equivalent

Capacity utilization
Percent
100

China JV
US
equivalent

3,600

76

Investment per car


US$
4,500

China JV
US
equivalent

4,5004,800

Reason for higher investment per unit capacity in China


Higher installation
costs

Shipping equipment to

Smaller scale plants

Lower line speeds set

China

Expatriate staff to

install equipment
More support
equipment (e.g.,
stable power supplies)

by capacity bottlenecks (such as paint


shops)
Similar investment in
paint shops for less
capacity (low scale
effects)

Source: UBS Warburg; plant visits; McKinsey Global Institute

Less automation
in welding

Chinese automation
levels = 30%
compared to 90% or
more in developed
countries

Higher investment
cost per unit
capacity

New plants in China


have higher investment per unit capacity
though roughly
equivalent actual
levels, given higher
capacity utilization

41

financial benefits from trading labor productivity for capital productivity by moving
from two to three shifts (exhibits 18-19).
Fine art of balancing global capabilities with local knowledge
The second critical execution challenge for global companies is to be able to
leverage their capabilities in a way that fits the local conditions of the host country.
Multinational companies have been well positioned to transfer their competitive
products and processes, but less equipped to tailor them appropriately to local
conditions. Strong local players have been well positioned to understand local
market conditions but often lack capital, product or process technologies. This is
particularly challenging in sectors like food retail where the local nature of
consumer food preferences and the need to build a local supply chain make deep
local knowledge critical, at the same time that capital intensive, technologyenabled investments can enhance performance greatly. Successful companies
have either acquired a local company and its management team or built local
management expertise over a longer time period (Exhibit 20). In manufacturing,
examples of successful products tailored for local demand include low-cost
passenger cars (Indica and Scorpio) targeting the low-income segments in India
(Exhibit 21), and white goods tailored for specific local needs (Exhibit 22).
The transition to a global economy provides great opportunities for bridging the
global-local gap by bringing together the capabilities of MNCs with local
knowledge of companies in developing countries and in the process, making this
distinction itself less meaningful. It is already hard to categorize cases like
Wal-Mart in Mexico, where the U.S. parent company owns 60 percent of WalMex,
Mexican listed company, that is managed by the acquired local management
team and that operates multi-format food retail operations that have a feel of
Cifra, the acquired Mexican company, more than the Wal-Mart known in the U.S.
Similarly the evolution of the Indian BPO sector has led to the creation of
companies that cover the full range of ownership and management structures
all in the attempt to maximize the benefits from combining global brand and
market access with local management expertise (Exhibit 23).
From multi-local to global optimization
The third critical execution challenge for global companies is to overcome their
internal organizational barriers to global change. The experiences of multinational
companies in our sample of 14 sectors and 4 countries suggest three key lessons
for senior managers:
Align management incentives with global, not local performance, but
allow for local tailoring. Many companies have been slow to capture the
benefits from offshoring because of the resistance of mid-level managers to
trade the costs of job losses and reduced managerial sphere of influence for
the large cost savings generated to the company. GE has overcome this barrier
through strong top-down mandate (Exhibit 24).

42

Exhibit 18

CAPITAL PRODUCTIVITY IS THE PRIMARY LEVER IN INDIA


Variable costs
Fixed costs

$/billable seat/hour
Voice Real-time processing

Multipurpose multi-

14.6

channel interaction
serving the needs of a
range of constituents
customers, prospects,
supply chain, distribution
channel, and employees

12.4

11.8
4.0

8.5

4.6

7.9

6.6

4.0
3.9

3.9

2.6

Two shift Three shift


per day
per day
(16 hours) (24 hours)

One shift
per day
(8 hours)

9.4

6.8

4.6

7.8

-36%
10.7

6.8

7.2

4.6

4.0

7.8

One shift
per day
(8 hours)

-43%

-45%

6.8

7.8
3.9

2.6

One shift
per day
(8 hours)

Two shift Three shift


per day
per day
(16 hours) (24 hours)

2.6

Two shift Three shift


per day
per day
(16 hours) (24 hours)

Nonvoice batch processing

Nonvoice seats

14.3

processing back-office
functions with turn
around time
exceeding 4 hours

10.1

-43%
6.9

3.8
6.3

3.1

7.4

6.3

Two shift Three shift


per day
per day
(16 hours) (24 hours)

6.3

8.0

3.1

2.1

Two shift Three shift


per day
per day
(16 hours) (24 hours)

One shift
per day
(8 hours)

10.1

8.0

4.3

3.1

2.1

8.0

6.4

4.3

3.8

-30%
11.1

-40%

4.3

5.9

3.8

One shift
per day
(8 hours)

10.6

One shift
per day
(8 hours)

2.1

Two shift Three shift


per day
per day
(16 hours) (24 hours)

Data entry and verification

Rules-based decision making

Knowledge-based services

Simple manual processes not

Services that do not require

Services requiring high value-

requiring decision making

add knowledge-based
professionals, e.g., engineers,
doctors, MBAs, scientists

managerial judgment and can


be performed with mechanical
rules-based directions with
minimal supervision

Source: Interviews; McKinsey Global Institute

Exhibit 19

INCREASING SHIFT UTILIZATION CAN IMPROVE PROFITABILITY


50%

Best practice
profitability

BPO provider profitability


$/seat/hour
Captive
average =
0.8 shifts

25

Potential best
practice
= 2.7 shifts

Current best practice


3rd-party provider =
1.7 shifts

Captive
benchmark for
profitability

Best practice net


profit margin =
28%

13.0

11.0

Potential impact
on net profit
margin = +14%

12.4
Price curve

11.0

Variable cost

10
7.8

4.3
3.8

5
Fixed cost
Variable cost

Variable cost

0
10 p.m.

Potential
improvement

Even best practice

20

15

1st
shift
3rd 2nd
shift shift

2 a.m.

6 a.m.

1st shift

Source: McKinsey Global Institute

10 a.m.
2nd shift

2 p.m.

6 p.m.
3rd shift

10 p.m.

providers can
increase profit by
further 50% by
increasing shift
utilization to
potential of 2.7
shifts/day
Relative to Indian
3rd - party
providers MNC
captives are highly
inefficient at
utilizing capital
and justify their
performance by
benchmarking to
foregone spends

43

Exhibit 20

COMPARISON OF FOOD RETAILER PERFORMANCE AND MIX


OF LOCAL KNOWLEDGE AND GLOBAL CAPABILITIES
Balancing local
knowledge vs.
global capabilities
is key for strong
performance in
food retail

Performance

Wal-Mart
CBD (Mexico)
(Brazil)

Carrefour
(Brazil)

Gigante
(Mexico)
Wal-Mart
(Brazil)
Greenfield/small
acquisition market entry

Big acquisition market


entry

100%
local
knowledge

Management/technology
skill mix

100%
global
capabilities

Source: Interviews; McKinsey

Exhibit 21

INDIA HAS EXHIBITED 2 KEY SUCCESS STORIES ON VEHICLE


DEVELOPMENT FRONT IN RECENT PAST
Indica development project

Development
time: 31
months

Cost and
process

Result

Scorpio development project

Development
time: ~60
months

Total project cost Rs. 1,700 crores, within this the


development cost was about Rs.206 crores and an
old plant bought from Nissan for Rs. 100 crores
(U.S. $22 mill)

Rs. 6,00 crores (U.S. $122.4 million) total development


costs with Rs. 250 crore (~U.S. $50 mill) for the design
development and Rs. 350 crore (~U.S. $70 mill) for
facilities upgradation

Indica has been designed by IDEA, Italy, test run in the


USA and some 700 engineers worked on this project
who had never designed a car before

The core product development team comprised


120 members broken up into 19 cross-functional teams
working using an integrated design and manufacturing
process (IDAM)

TELCO Developed some 3,800-odd components and


nearly 700 plus dyes and 4,000 fixtures. Partnered
with 300 vendors to develop nearly 77% of the value
of the vehicle

74 prototypes made till final launch. Undertook 5 customer


surveys over 1997-2002 to understand changing customer
expectations

Le Moteur Moderne, France developed both gasoline


and diesel engines

Developed diesel engine in-house in collaboration with


AVL, Austria and tapped Renault (for the petrol engine)

Got some 115,000 orders with the initial deposit money


on launch

Received the Best Product Launch of the year award


at the India Leadership Summit in Nov 2002

Currently market leader in diesel small car category

Set a sales target of 1,200 units per month, but actually


clocking around 2,000 units per month

Source: Press; Web Search; company release

44

Exhibit 22

UNIQUE WHITE GOODS CHARACTERISTICS DRIVEN BY TOTAL NEEDS


Local need/condition

Product characteristics

India
Scarcity of water, with high-cost
water supply

Double basin clothes


washer, which allows for
reuse of water

Europe
Heightened environmental
concern and more frequent trips
for food shopping

Smaller, more efficient


refrigerators than
American counterparts

China
Because many families live in
one-room apartments,
refrigerators are often in the living
room; they are often given as
wedding gifts

Refrigerators styled
towards living room decor;
picture frame integrated
for wedding picture

Source: McKinsey Analysis

Exhibit 23

INDIA BPO SERVICES INDUSTRY EVOLUTION


Size of provider
Post-dotcom era

Indian
ownership/
control

The roaring 90s


Pre-liberalization era

Wholly
owned
Indian
company

Progeon
eServe

Wipro Spectramind

Domestic

Gaksh

Majority
Indian
ownership

Gaksh
Transworks

Transworks
MsourcE

Spectramind

EXL

Majority
Foreign
ownership

WNS
Citigroup

MNC Spinoff

Convergys

MNC
subsidiaries/
captives
Foreign
ownership/
control

1975

Convergys

MsourcE
GE
British
Airways

80

Source: McKinsey Global Institute

85

90

92

94

96

GE

Conseco

98

2000

2001

2002

champions
emerge
from the
presence
of foreign
players
Management
trained by
MNCs
launch local
companies
Indian
software
companies
move into
BPO space

45

Exhibit 24

BIGGEST BARRIER TO GLOBAL SOURCING OF SERVICES IS


CORPORATE COLLECTIVE ACTION PROBLEM
Number of FTEs

14,000

Unless driven from the top down,


Top-down
prescriptive
approach
(CEO
mandate)

12,000

10,000

Companies need to redesign

8,000

Bottom-up
subscriptive
approach (BUhead initiative)

6,000

4,000

incentive structures to make midlevel managers think like CEOs


within their sphere of influence,
i.e., push P&L deep into the
organizations

Allowing BU heads to retain control

2,000

0
1998

most mid-level managers resist


offshoring despite the obvious
value created for the company
because the disadvantages are
disproportionately borne by a few
(i.e., loss of jobs; reduced
managerial sphere of influence)

1999

2000

2001

Source: Interviews; McKinsey Global Institute

2002

of operational staff while the


offshored service center manages
support functions (e.g., HR,
technology, etc.) has allowed
companies taking the subscriptive
offer approach to increase their
pace of offshoring in the short term

46

Exhibit 25
Retail banking Mexico

MNCS ADOPTED BROAD RANGE OF MANAGEMENT APPROACHES IN


THEIR MEXICAN OPERATIONS
Execution focus

Performance pressure

Mentoring approach

Example

BBVA Bancomer

Santander Serfin

Citigroup Banamex

Description

Local management

Local management is given

Local management is given

executes decisions made


by parent company
Little focus on independent
thinking and initiative by
local management

performance targets based


on group benchmarks
Up to local management to
decide how to meet topdown targets

autonomy under guidance


of parent company
executives
Local management
encouraged to adopt best
practice developed in other
parts of the organization

Top management in

Subsidiary run by a

Subsidiary run mostly by

subsidiary replaced by
senior managers from
parent company
Key management decisions
taken by parent company

combination of local and


parent company executives
Operational control by
parent company with clear
line authority over local
management

Clear and direct transfer of

Model emphasizes local

best practice through


central line of command
Approach favours best
practice over local content

content rather than best


practice
Santander fosters best
practice transfer through
internal consulting unit

Internal
organization

Skill transfer

Source: Interviews

local executives

Multiple reporting lines


within matrix-like structure

Mentoring approach tries to


strike balance between
local content and best
practice

47

Eliminate barriers to innovate and take risks in search of restructuring


opportunities. The relatively short rotation time of auto OEM country
managers limits their incentives to "tinker with the model" by seeking lower-cost
local suppliers instead of relying on global supply chain partners. On the other
hand, overinvestment may be encouraged if managers get credit for expansion
but are not responsible for seeing that expansion results in an appropriate
increase in returns.
Create feed-back mechanisms to avoid repeated mistakes. Local
innovation needs to be encouraged but balanced against inappropriate
organizational trial-and-error strategies. Global retailers ought not repeat
product selection mistakes like selling ski boots in So Paulo or sit-on lawnmowers in Mexico City.
There is no one correct approach to managing global optimization. Just as highperforming companies in developed countries exhibit a broad range of successful
management approaches, so too in the large developing economies. In Mexican
retail banking, successful approaches ranged from BBV's top-down direction to
Citigroup's management coaching of the executives in their newly acquired
Mexican operations (Exhibit 25).
***
The changing global landscape creates very large opportunities for cost savings
and revenue creation. Incremental performance mandates will be increasingly
inappropriate as bold targets come within reach. These opportunities for value
creation will be captured by companies that understand where the potential
restructuring opportunities lie in their sector, are able to remove any existing
barriers to globalization, and can succeed in execution.

48

Exhibit 26

POTENTIAL FUTURE VALUE CAPTURE FOR THE AUTO SECTOR


Better capacity utilization increasing trade among more specialized plants

Cost of
capital
15%

2 Better utilize existing capacity


E.g., more trade among more specialized
plants

e
ad
Tr

Sales
Chevrolet TrailBlazer $1.2 trillion*
(Dayton, OH)

Sales/net
fixed
assets**
3.67

Net fixed
investment
in auto
industry =
$327
billion

Increase
in capacity
utilization
20%***

Pontiac Aztek
Ramos Arizpe, Mexico

~$10 billion
in annual
savings

Savings
in net
fixed
investments
$65
billion

* Estimated market size in 2002


** Industry average for global automotive and light trucks manufacturers having a market cap excess of
$100 million; 30 companies benchmarked
*** Due to increasing utilization of existing plants
Source: SEC documents; interviews; literature searches; McKinsey Global Institute

Exhibit 27

POTENTIAL FUTURE VALUE CAPTURE FOR THE AUTO SECTOR (continued)


Reduced product cost through massive shift of production (e.g., 70%) to low labor cost
emerging-nation production sites

3 Shift production to LLC zones


Auto: China/USA

U.S.
China/India
production

U.S.,
Canada,
Europe, and
Japan car
production in
2007*
46 million
units

Average cost
of production
per car **
$18,393

Share
offshored to
developing
countries
70%***

Cost of
production for
developed
markets in
2007
$846 billion

Percent
cost
savings
from
offshoring
production
25%****

Estimated
$148 billion
in savings

Production
costs
offshored to
developing
countries
$592 billion

* Assumes an 1% CAGR applied to ~ 44 million cars produced in US, Japan, Canada, and Europe in 2002; Europe includes Eastern and Western
Europe production figures; used as a proxy for developed worlds production
** Average for GM, Ford, and Daimler Chrysler in 2000, as reported by Goldman Sachs; used as a proxy for developed world
*** Assumes that some production must be kept local
****Cost savings from offshoring to LLC usually results in 20-25% savings see Global Industry Restructuring piece for more details; here we
assumed the upper end of this spectrum since the percentage savings does not take into consideration the effects of falling tariffs
Source: Global Insight; literature searches; Goldman Sachs research; McKinsey Global Institute

49

Exhibit 28

POTENTIAL FUTURE VALUE CAPTURE FOR THE AUTO SECTOR (continued)


Disaggregation of value chain permits specialization at each stage, gaining thereby economies of
scale and scope
4 Alter production technology
Disaggregation

Factors promoting and hindering disaggregation

Potential for several tens of


billions of savings globally, but
precise amount depends on
company specific strategies (e.g.,
product customization, supplier
dependency, brand differentiation)

Hindering

Promoting

Brand differentiation plans may

Pooling demand

insist on non-standardized parts

permits investment in
new methods
Supplier concentration
allows OEMs to drive
part standardization,
thereby cutting costs
Concentrating demand
in specialists
accelerates learning
curve effects

Short-order-cycle customization
strategy would require sitting
parts plants near car plant

Unlike many other industries,

Sourcing strategy may block


dependence on a very small
number of suppliers
Technological innovation may fall
to yield new scale economy
curves

scale economies in the auto


industry beyond current plant size
mostly conjectural, as a result
improvement less than options 1
and 2

Source: Interviews; McKinsey Global Institute

Exhibit 29

POTENTIAL FUTURE VALUE CAPTURE FOR THE AUTO SECTOR (continued)


If Horizons 2, 3, and 4 were used in part to reduce price significantly, demand could be boosted
and net profits expanded dramatically
5 Lower cost model taps new markets
Price/unit

1 No impact from lower price model


Demand for average price car**
14.8 million

$10,500
Demand
(2007) in
developing
countries

$7,350
0

Sales volume in the


developing world in 2007*

22.2

38.9
Quantity (millions)

Average price of car


$10,500
2 Price erosion from lower price model
Demand for people purchasing lower price
model rather than average price model**
7.4 million

66% of market ($ 155


billion) unaffected by
introduction of lower cost
model
Revenue impact $ 0 billion

Price erosion of
$23 billion

Revenue lost from people buying


lower price model***
$3,150

Issues:
1.
Environmental impact
2.
Stability of 2.5 elasticity

3 New market creation


Demand for lower price model****
16.7 million

Price of lower cost model****


$7,350

New revenue created from


introduction of lower cost
model
$123 billion
Additional revenue
in developing world
~$ 100 billion

* To determine sales volume in 2007, we applied an 8% CAGR to ~ 15.1 million cars produced in the developing world in 2002, resulting in an expected demand of 22.2 million units
** We assumed that 2/3 of demand was unaffected by the introduction of this lower cost model (2/3 * 22.2 million = 14.8 million); 1/3 of the market substituted lower price model car for the average
price car (1/3 * 22.2 = 7.4 million)
*** The difference between the average price of a car ($10,500) and the lower cost model ($7,350) assumes that lower price model is 30% less expensive than average price car
**** Assumes a price elasticity of 2.5 and 30% decrease in price (average car price was $10,500, now reduced to $7,350); % change in volume = % change in price * price elasticity = 75% boost in
volume (22.2 million *1.75 = 38.9 million for new market size); we assume that all of the increase in market size (38.9 million - 22.2 million = 16.7 million) is for lower price models

50

Exhibit 30

POTENTIAL FUTURE VALUE CAPTURE FOR THE AUTO SECTOR (continued)


If Horizons 2, 3, and 4 were used in part to reduce price significantly, demand could be boosted
and net profits expanded dramatically
US new market
opportunity
Number of
households
106 million
Percent of
population
not owning
cars
8%

Number of
households
106 million
Percent of
population
owning 1-2
cars**
72.6

Households
not owning
cars
8.5 million
Households
willing/able to
purchase cars
at lower
prices*
50%
Households
owning 1-2
cars
77 million
Households
willing to
purchase
additional
car at lower
prices***
5-10%

New
model car
price
$7,000****

Revenue
from new
car buyers
$ 30 billion

New car
buyers in US
4.3 million

Lower cost
model car
price
$7,000****

Additional car
purchases in US
6.2 million

Potential
additional revenue
in U.S. from
introduction of
lower cost model
= ~ $ 73 billion
Revenue
from
additional
car
purchases
$ 43 billion

Potential for same


type of revenue
generation in W.
Europe and Japan,
not captured here

* Assumes that 80% of households who do not own cars simply cannot afford to do so; when a lower cost model is offered, 60% of those households choose to buy one; some household
may buy used cars
** 34. 2% of the population owns 1 car; 38.4% of the population owns 2 cars
*** In order to calculate the revenue generation, our calculation assumes that 8% of people who own 1 or 2 cars will purchase an additional lower cost model (rough midpoint between 5-10%)
**** Assumes 30% decrease in lowest cost US model - KIA Rio (~$10,000)
Source: Census 2000; Global Insight; literature searches; McKinsey Global Institute

Preface to the
Auto Sector Cases
The auto sectors of Brazil, Mexico, China, and India are four of the major emerging
markets in the auto industry, each of which possess quite distinct characteristics.
Though the countries concerned are all large, developing nations, the policies
pursued by each country toward the auto industry and the resulting development
of the industries have been quite different. The industry size in each country
varies, from the high of 1.8 million units a year produced in Mexico to a low of
0.6 million units a year produced in India. Similarly, the nature of the industry is
also varied, with exports accounting for as high as 74 percent of production in
Mexico, to a low of less than one percent in China. This preface provides the
background information necessary for a full understanding of the comparative
cases.
BACKGROUND AND DEFINITIONS
Sector scope. The study scope of the auto cases has been limited to an
examination of the performance of OEMs in the passenger car segment. OEMs in
passenger cars account for roughly 50 percent of total value-add in a car (Exhibit
1). In some cases, where appropriate, we have extended this scope to include
other light commercial vehicle (LCV) segments like vans and pick-ups (Exhibit 2).
For example, in Brazil and Mexico, in addition to passenger cars, we have included
vans, pick-ups, and other LCVs produced by the same manufacturers and in the
same plants as passenger cars. In China, in addition to the LCV segment, we have
also included the bus and truck segments solely as comparators to highlight the
impact FDI on the passenger vehicle segment. In each case, we have also studied
the impact of FDI on the component industry, to understand how FDI creates
backward linkages (spillover effects) to suppliers. The scope of the study does not
include distributors/dealers or the aftermarket segments.
Country selection. We have studied the impact of FDI on the auto sector in four
countries Brazil, Mexico, China, and India (Exhibit 3).
These countries are four of the five largest emerging markets in the industry,
accounting for 51 percent of total emerging market production (Exhibit 4).
The auto sector is a significant industry across all four countries, accounting for
an average GDP and employment share (Exhibit 5). The industry is at different
stages of development in each country, with productivity levels varying from a
low of 21 in China to a high of 65 in Mexico1 (Exhibit 6).
Given the economic significance of the auto sector to each of the countries
concerned and its importance as a symbol of modernity and of national
advancement, each country has regulated the industry to varying degrees.
Consistent with our approach in other sectors, we have selected two different
focus periods in order to be able to compare and isolate the impact of FDI, both
within the country and across countries.
The auto industry in developing countries
The auto industry is a highly capital-intensive sector requiring substantial R&D
1.

We have used productivity in the U.S. as a comparison, where U.S. productivity = 100.

Exhibit 1

OEM IN PASSENGER CARS ACCOUNT FOR NEARLY HALF OF THE


TOTAL VALUE ADD IN A CAR
Dollars per vehicle
Dealers
OEM

Tiers 1-3
raw materials

1,600

1,200

500

500

600

1,150

750

400

1,600

24,500

Average
transaction
price

22900

2,400
2,000
11,800

1,770 *

10,030 **

Material
costs

Maint.,
Repair,
Ops
costs

Manufacturing
costs

8.5%

10.5%

52%

Product
development

Transportation

7%

2.2%

Sales & DepreMarketing ciation


and
interest

Warranty
costs

5%

5%

2.6%

General & Taxes


Admin.

1.7%

Net profit

Wholesale
to dealer

Dealer
gross

3.3%

100%

6.8%

1.7%

~ 60%
47.5%

* Raw materials
** Purchase parts
Source: Roland Berger; Deutsche Bank Report; team analysis

Exhibit 2

FOCUS OF ANALYSIS IN THE AUTO SECTOR

Products/
services
supplied

Suppliers of material,
components and
systems

Original equipment
manufacturers
(OEMs)

Assembly of car parts

Distributors/
dealers

Aftermarket

Design of cars
Organization of

Retail new car

All activities related to

production
Final assembly
Marketing and sales
Financing services

Financing services
Used car purchase and

Mostly rather small

Example
companies

Delphi
Magna
Visteon

Market
segmentation

All kinds of autoparts,

Passenger cars

100% =
58 million
units worldwide

components systems
and raw material

Mini and
small (19%)

* Multi-person vehicle (e.g., mini-vans)


** Includes SUVs
Source: Procar World; McKinsey Global Institute

Focus

GM
Ford
Toyota
DaimlerChryster

(by size, by brand


image)
Light commercial
vehicles (LCVs)
Trucks, buses (not
addressed)

Medium (40%)

distribution

sales

dealers

car usage, e.g.,


Maintenance, repair
Vehicle parts
Fuel
Recycling
Planning
Etc.
Many small companies
Large fuel chains
include ExxonMobil,
Royal Dutch/Shell
Group, etc.

Captive vs. non-captive Along activity


dealers

performed

Wholesaler vs.
retailer

Luxury/
sport
(4%)

Van/MPV*
(13%)

Pick-ups/
offroad**
(19%)

Trucks,
buses,
and other
(5%)

Exhibit 3

PROFILE OF AUTO SECTOR CASES

Production:
Exports:
Employment*:
Productivity**:

1.1 million
<1%
1,807,000
21

1.8 million
74%
473,000***
65

Production:
Exports:
Employment*:
Productivity**:

China
Production:
Exports:
Employment*:
Productivity**:

Mexico
India
Brazil
Production:
Exports:
Employment*:
Productivity**:

Source:

0.6 million
9%
281,000
24

1.7 million
24%
255,000
32

* Including components
**Benchmarked to U.S. at 100; India and Brazil are far below their potential productivity due to low capacity utilization
*** Including maquiladora employment of 211,000
ANFAVEA; SINDIPECAS; INEGI; ACMA; CRIS-INFAC; McKinsey Global Institute

Exhibit 4

LIGHT VEHICLE PRODUCTION IN EMERGING MARKETS 2002


Percent

Emerging Markets
100% = 13 million units
13

Worldwide production
100% = 56 million units

2
2
3
3
3
3
3
4
4

JapanKorea

22
U.S. and
Canada

Focus of study

26

23 Other

13

8 Others*
Poland
Taiwan
Turkey
Australia
South Africa
Iran
Czech Republic
Malaysia
Thailand
India
Russia
Brazil

29
Western
Europe

Mexico
14

18

China**

* Indonesia, Slovakia, Argentina, Hungary, Slovenia, Venezuela, Romania, and Philippines each produced less than 300,000 units
** Figure includes passenger cars and light commercial vehicles (e.g., light trucks), China auto case study excludes light commercial
vehicles and consequently results in a smaller sample size; numbers will not exactly match auto case study
Source: Global Insight

51%

Exhibit 5

AUTO IS A SIGNIFICANT INDUSTRY FOR MANY COUNTRIES


Share of GDP*

0.8

1.1

U.S.

1.2

2.0

Japan

3.5

2.5

Korea

0.4

0.8

Brazil

1.5

2.8

Mexico

0.2

0.8

China

0.4

0.5

India

*
**
Note:
Source:

Share of employment**

Auto sales as a percentage of GDP


Percent of auto employment/total employment
Data for share GDP 2002; data for share of employment 1998 (India), 1999 (Korea, China) or 2001 (U.S., Japan, Brazil, Mexico)
McKinsey Global Institute

Exhibit 6

SIGNIFICANT PRODUCTIVITY DIFFERENCES EXIST ACROSS COUNTRIES


Labor productivity in the auto sector
U.S. productivity = 100

U.S.

100

Mexico

65

Auto industry is less traded than


other sectors

There is therefore huge potential


Brazil

India

China

32

for FDI to raise productivity levels


to best practice

24

21

Note: India and Brazil are far below their potential productivity due to low capacity utilization
Source: McKinsey Global Institute

and very large fixed investment upfront. It therefore has large economies of
scale.2 Passenger cars tend to be even more capital-intensive than trucks and
SUVs as a result of higher design and assembly costs. Unlike trucks and SUVs
in which a frame is the basic building block to which all parts are attached, cars
are almost always built using "unit body" construction, where each piece of the
car needs to be welded together; a costly process requiring more time in the
body shop. Because of the large capital investments necessary for this industry
FDI is usually the primary catalyst for jump-starting this sector in most
emerging markets. Countries that do not allow FDI, end up relying on outdated
products purchased from global companies. Our cases range from Brazil with
100 percent FDI-led industry to China and India where FDI was banned until
the 1980s or 1990s.
In order to capture economies of scale, OEMs need to produce a minimum of
250,000 vehicles per year (Exhibit 7). Most developing countries are forced to
run sub-scale operations as a result of smaller market size, where the vehicles
produced per plant are well below the amount needed to capture full
economies of scale benefits (Exhibit 8). For example, in 2002, OEMs produced
an average of 127,000 vehicles per plant in Mexico, 95,000 in Brazil, 72,000
in China, and 42,000 in India.
FDI typology.
FDI in the auto industry can be both market-seeking and
efficiency-seeking. The majority of the production in Mexico is efficiency seeking
(70 percent), aimed at export to the U.S. market. China and India both attract
market-seeking FDI that is made, at least part, to circumvent high trade barriers.
Brazil attracts both market-seeking and efficiency-seeking FDI; to a certain extent,
the two feed off of each other.
SOURCES
Data. For Brazil, Mexico, and China, productivity, output, and employment
estimates were based on government statistical sources, industry associations,
company websites, and annual reports. For India, financial and operational
information was collected, analyzed, and aggregated from interviews with each
OEM.
Interviews. The analysis of industry dynamics and the impact of external factors
on the sector were based on interviews with company executives, government
officials, industry analysts, and industry associations. Almost every leading OEM
was interviewed in each country. Furthermore, these same sources were used to
understand and verify the impact of FDI on productivity and, in particular, what
operational factors might have influenced it.

2.

The auto sector value chain can be broken down into four processes: body stamping,
welding/body shop work, painting, and physically assembling the car (e.g., on a conveyor belt
using power tools). The majority of scale benefits tend to come from the painting work
segment - the automated painting machinery is expensive and runs at the same rate all day,
regardless of the number of cars produced.

Exhibit 7

EMERGING MARKET CAR PLANTS ARE OFTEN SUB-OPTIMAL IN EITHER


SCALE OR UTILIZATION OR BOTH, LEADING TO LOWER PRODUCTIVITY
Assembly Plant Scale and Utilization Targets*
Thousands of units per year
250
Typical NA or EU break-even utilization: ~80%

Utilization in emerging
markets often much lower
due to volatile demand

127
9595
72
72

42
42

Standard
Plant**

Mexico

Brazil

China

India

* Averages for each country in 2002, except China (2001); equals total production/number of plants in the country
**Typical Triad plant scale, for mid-sized car (e.g., Taurus, Camry, Passat), based on 2-shift operations running 60-second take time and assuming
highly automated paint and welding shops; can be reduced to 150,000 via 3-shift operations and even lower if labor substituted for capital (e.g.,
manual painting), but at that point quality drops below world standards
Source: Interviews; McKinsey analysis

Exhibit 8

LOWER PRODUCTIVITY OF MNCS IN DEVELOPING COUNTRIES LARGELY


DRIVEN BY LACK OF SCALE AND POOR UTILIZATION
INDIA EXAMPLE
Equivalent cars per employee*, indexed to U.S. average
52
19
27

22
5
Pre-liberalisation
plants

Causes

Excess
workers,
OFT, DFM,
techno-logy

Post-libera- Skill
lisation plants
(excl. Maruti)

Less

Supplier
relations

Less JIT
experience Lower
product
quality

Scale/
Utilization

Maruti

Less
indirect
labour per
car produced
Higher
output

* Excluding sales, R&D, powertrain, etc., and adjusted for hours worked per year
Source: Interviews, SIAM, INFAC; McKinsey Global Institute

Auto Sector Synthesis


FDI has the potential to play a critical role in improving the performance of the
auto industry globally. This is because in addition to upfront large capital
investments for production, the auto sector also requires massive product
development costs for new models and proprietary technology. Given the broad
applicability of similar products across borders and the resulting benefits from
leveraging global economies of scale, multinational companies are in a unique
position to deliver benefits to emerging markets consumers. FDI therefore has the
potential to jump-start the auto industry in developing countries by contributing
not just capital but also proprietary R&D and technology that can take years for
local OEMs to acquire.
FDI has proven to be a necessary, but not alone sufficient condition, for
modernizing the auto industry in most developing countries. Once FDI is present
in the country, conventional market forces old-fashioned competition and
managerial innovation matter a great deal and the resulting economic impact
can be highly varied. This is demonstrated vividly by our four country cases. For
example, FDI created a strong positive impact on Mexico and India auto sectors,
but its impact in China and Brazil was only categorized as positive. Given the
differences in cross-border productivity in the auto industry, its significant
importance to most economies, and the huge opportunity for performance
improvement from FDI, it is important to understand why FDI had a varied
outcome across our four sector cases.
GLOBAL INDUSTRY TRENDS
Given these significant differences in cross-border productivity, it is useful to first
understand the global industry trends that contribute to this varied outcome.
The auto industry is a $1.2 trillion industry (Exhibit 1) dominated by a small
group of global competitors who sell products into virtually every market in the
world. The industry has gone through dramatic consolidation since the 1950s
(Exhibit 2). Today, five OEMs control more than half the global market
(Exhibit 3). However, the industry lags many others in its performance along a
number of conventional metrics. For example, it offers one of the lowest
returns to its shareholders (Exhibit 4), has one of the lowest profitability levels
(Exhibit 5), and has demonstrated low levels growth relative to most other
industries (Exhibit 6).
Although global players have captured market share in most developing
countries, local players do survive in other developing countries. The key to
their survival is their ability to capitalize on local capabilities in product
development, production, and distribution and to source technologies through
international partnerships. However, given the overwhelming economies of
global scale in this industry, the future of local players is uncertain.
Relative to industries like consumer electronics, the auto sector is less global
(Exhibit 7). While the industry has recently begun to disaggregate its production
process to improve performance, it is increasing the level of globalization at a
relatively slow rate (Exhibit 8). Neither does this rate appear to be increasing
over time (Exhibit 9).

Exhibit 1

GLOBAL SALES/PRODUCTION LANDSCAPE

Production
Sales

Units, Millions, 2002


World production =

Global market size ~$1.2 trillion

E. Europe/Central Europe

56.6 million units

World sales =

2.9

53.8 million units

2.5

Korea
3.10
3.1

W. Europe
16.5

1.6
1.61

16.2

Japan

U.S. and Canada


18.5
14.6

10.0
5.7

China*
2.8
Mexico

0.6
1.71
1.8

3.0

India
0.5

1.01
1.0

Africa and Middle East


Other South America**
0.3

0.5

Brazil
1.6
1.7

1.5
1.4

0.9

Other Pacific***

1.2

1.7

2.0

* Figures includes passenger cars and light vehicles (e.g., light trucks); China auto case excludes light vehicles and
consequently results in a small sample size; numbers will not exactly match auto case study
** Excluding Brazil
*** Other Pacific includes Australia, Indonesia, Malaysia, Philippines
Source: UN PCTAS database; McKinsey Analysis

Exhibit 2

AUTO INDUSTRY HAS UNDERGONE DRAMATIC CONSOLIDATION


52
NSU
Auto-Union (DB)
VW
Seat (Fiat)
Lamborghini
Rolls-Royce
BMW
GLAS
Austin
Triumph
Jaguar
Morris
Rover
MG
BMC
Daimler-Benz
Chrysler
AMC
Mitsubishi
Porsche
Alfa Romeo
Abarth
Autobianchi
Fiat
Lancia
Forrari
DeTomaso
Innocenti
Maserati
Rootes
Simca
Peugeot
Citroen
Panhard
Alpine
Renault
Lotus
GM
Saab
Suzuki
Volvo
Aston Martin
Ford
Stude Baker
Toyota
Nissan
Honda
Isuzu
Mazda
Daihatsu
Fuji
Prince

Source: Deutsche Bank report

Only a fourth of all car manufacturers have kept their economic


independence since 1964

Number of independent automotive manufacturers


30

VW
Seat (Fiat)
Lamborghini
Rolls-Royce
BMW
BL/Rover
Daimler-Benz
Chrysler
AMC
Mitsubishi
Porsche
Alfa Romeo
Fiat
De Tormaso
Talbot
Peugeot/Citroen
Renault
Lotus
GM
Saab
Suzuki
Volvo
Aston Martin
Ford
Jaguar
Toyota
Nissan
Honda
Hyundai
Daewoo

12
VW
BMW
DaimlerChrysler
Porsche
PSA
GM
Ford
Renault
Toyota
Honda
Hyundai
Rover

Exhibit 3

TOP 5 OEMs HAVE MORE THAN HALF THE SHARE OF THE


GLOBAL OEM MARKET
2002 global revenues from light vehicles** business
$ Billions
159.7

GM

15.6

134.4
121.4

Ford
Toyota

11.8

73.3

VW

Foreign sales**
as percent of
total
17.7

13.1

100.7

DaimlerChrysler

Market share
Percent

Top 5 OEMs

33.2
57%

56.5

9.8

68.9

7.1

33.1

Nissan

52.9

5.2

62.6

Honda

52.9
51.1

5.1

75.2

5.0

9.9

32.6

3.2

11.4

Peugeot
Renault

31.6

3.1

44.5

3.0

59.3

Fiat

31.3
21.8

2.1

26.0

Hyundai

21.1

2.1

18.7

Mazda

19.4

1.9

53.0

BMW
Mitsubishi

Suzuki

13.3

1.3

44.2

Kia

11.7

1.1

36.2

Isuzu

11.6

1.1

45.0

Fuji (Subaru)

9.2

0.9

41.0

0.4

46.7

Porsche

3.9

* Total OEM revenues $1,120 billion


** Based on Total Dollar Sales 2002
Source: Annual reports; Bloomberg; Hoovers; McKinsey Automotive Practice

Exhibit 4

AUTO AND COMPONENTS OEMS UNDERPERFORM MOST INDUSTRIES


Percent
Average yearly TRS* of U.S. Companies in S&P 500, 1997-2001

Software & Services


Diversified Financials
Retailing
Pharmaceuticals & Biotech
Insurance
Technology Hardware & Equipment
Food & Drug Retailing
Media
Capital Goods
Banks
Health Care Equipment & Services
Utilities
Household & Personal Products
Energy
Food Beverage & Tobacco
Telecommunication Services
Commercial Services & Supplies
Automobiles & Components
Transportation
Hotels Restaurants & Leisure
Materials
Consumer Durables & Apparel
* Total return to shareholders
Source: McKinsey analysis

27.7
25.2
25.2
24.0
19.5
19.3
17.1
17.0
13.9
13.7
13.2
12.7
11.1
11.0
10.5
10.3
7.9
6.9
6.8
6.5
2.4
-1.1

10

Exhibit 5

AUTO AND COMPONENTS OEMs HAVE LOW MARGINS


Percent
Average yearly margins of U.S. Companies in S&P 500, 1997-2001

Diversified financials
Banks
Pharmaceuticals & Biotechnology
Telecommunication Services
Software & Services
Media
Insurance
Household & Personal Products
Commercial Services & Supplies
Hotels Restaurants & Leisure
Food, Beverage & Tobacco
Utilities
Capital Goods
Transportation
Materials
Consumer Durables & Apparel
Energy
Health Care Equipment & Services
Automobiles & Components
Technology Hardware & Equipment
Retailing
Food & Drug Retailing

33.5
19.0
17.8
16.1
15.1
14.1
12.0
11.4
11.2
10.7
10.5
8.6
8.3
7.7
7.1
7.1
6.5
5.9
5.8
5.2
4.2
2.9

Source: McKinsey analysis

Exhibit 6

GROWTH IS NOT A KEY DRIVER OF PERFORMANCE FOR AUTO


INDUSTRY IN THE WESTERN WORLD
US EXAMPLE
Average yearly sales growth of U.S. companies in S&P 500, 1997-2001; percent

Utilities
Software & Services
Diversified Financials
Health Care Equipment & Services
Retailing
Food & Drug Retailing
Pharmaceuticals & Biotechnology
Commercial Services & Supplies
Media
Insurance
Technology Hardware & Equipment
Telecommunication Services
Hotels Restaurants & Leisure
Energy
Capital Goods
Banks
Transportation
Food, Beverage & Tobacco
Consumer Durables & Apparel
Automobiles & Components
Household & Personal Products
Materials
Source: McKinsey analysis

29.7
27.1
19.7
18.9
12.7
10.5
10.3
10.2
8.3
8.1
7.2
6.4
5.8
5.1
4.1
3.1
2.1
2.1
1.8
1.5
0.2
-2.2

11

Exhibit 7

AUTO INDUSTRY IS LESS GLOBALIZED THAN CONSUMER ELECTRONICS


OR APPAREL
Measures of global industry restructuring, 2000
Global sales
$ Billions
Consumer
electronics

118

496

640.5

Auto

Trade/sales ratio
Percent

650

550

Apparel

Steel

Global trade
$ Billions

77

500

1,200

42

81

249

IT/BPO*

33

32

3,000

* IT/BPO sales figure includes all IT/BPO exchanges


Source: UN PCTAS database; IISI, Statistical Year Book 2000; Datamonitor

Exhibit 8

CHANGE IN TRADE AND PRODUCTION (1996-2000)


Percent

Growth in exports

IT/BPO*
Consumer
electronics
Steel

Growth in sales

31.4
8.4
6.2

Difference

12.3
2.2
3.2

Apparel**

4.4

1.7

Auto

4.2

2.6

19.1
6.2
3.0
2.7
1.6

* Growth in exports and sales 1997-2000


** Growth in exports 1995-2000; growth in sales 1997-2000
Source: UN PCTAS database; International Trade Statistics 2002; IDC; Euromonitor; China Light Industry Yearbook;
McKinsey analysis

12

Exhibit 9

U.S. BASED AUTO COMPANIES GLOBALIZATION HAS REMAINED


STEADY OVER TIME
1910

Manufacturing
presence*

General
Motors
Formal sales
presence*

1920

1930

Plants opened in
Denmark, Argentina,
Germany, Australia,
Japan and India (2326)

Adam Opel AG (based


in Germany) acquired
(29)

Subsidiaries in Brasil,
Spain, France, Germany,
South Africa, Australia,
Japan, Egypt, Uruguaya
and China(25-26)
First overseas plant in
England (11)

1940

1950

1960

New plant in Bochum,


Germany (62)

1970

New plant in Spain (82)

Plants in Peru and


Caracas (45-48)

Subsidiary in Mexico
and Switzerland (35)

Subsidiary in Chile (69)

Plants in Japan and


Germany

2000
onwards

1990

Joint Venture in
Indonesia (93)

New plants in Thailand


and Russia and
acquisition of Daewoo
(00-02)

Two plants in Turkey and


manufacturing agreements
in Russia, Hungary and
China (89-90)

GM holds first auto


exhibit in Russia (59)

Plant in Argentina (16)

1980

European Advisory International Product Strategic alliances with


Council formed (73) Center formed to
Isuzu, Honda and Fiat
enhance export
(98-00)
activities (96)

Several European
plants

Plants in China and


India (94)

Ford
Sales in China, France,
Indonesia, Siam and
India (13)

Sales in Europe, South


Africa and Asia (18)

Ford Asia Pacific


established (70)

Ford Europe
established (67)

Plant in Brazil (59)

Ford Latin America


established (74-75)

Plants in Australia and


South Africa (63)

Plants in Asia and U.S.

Ford of Korea
established (86)

Sales Office in Russia


(96)

Plants in Kenia and Several plants all over


Venezuela (81)
the world

Toyota

Subsidiary in China
(21)

Subsidiary in Taiwan
(29)

Patent royalty
agreement with British
company (49)

Subsidiaries in El
Salvador, Saudi Arabia
and Honduras (53-56)

Exports to Soviet Union


(60)

Several Subsidiaries all


over the world

* Not all expansion activities accounted for


Source: Company Web sites; press clippings; McKinsey analysis

Exhibit 10

EMERGING MARKETS OFFER GROWTH OPPORTUNITY


Total World Car Production
Million cars

CAGR*
Percent

25

20

Europe

2.7

15

U.S. and
Canada

1.6
6.7

10

Emerging
markets
Japan

0
1960

1970

1980

* 1960-2000
Source: Wards 2001 Year Book (Page-16); McKinsey Global Institute

1990

2000

7.9

13

As the industry matures, there are modest growth opportunities in the OEMs'
home markets, so they are being encouraged to enter emerging markets in
order to tap the large potential for growth found there (Exhibit 10). However,
this usually takes the form of market-seeking investments seeking to sell locally
(exhibits 11 and 12). Driven in large part by regulation and protection, the
industry has yet to exploit the potential of low-cost sourcing and to
disaggregate production at the global level (Exhibit 13).
Due partly to a highly inefficient and disaggregated production process, there
is large overcapacity in the industry, as OEMs are unable to balance demand
and supply through trade. In addition, due to requirements for local production
in certain countries where demand is low, OEMs are forced to invest in
subscale plants and suffer from significant diseconomies of scale.
EXPLANATION FOR THE VARIED IMPACT OF FDI
We found FDI to be a crucial driver of performance, but its impact was varied
across all four cases. FDI has created a very positive impact on Mexico and India
auto sectors. However, its impact in China and Brazil was categorized as positive.
The following factors explain the differences:
Government actions that distort supply. Government actions can distort
the level of supply, either by increasing supply by offering incentives or imposing
trade barriers (forcing OEMs to setup plants), or by reducing it by imposing
licensing requirements all which distort supply and dampen the potential
impact that FDI can create.
Incentives. We found that the incentives governments use to attract FDI
often adversely influence the impact of FDI. The most extreme example of
this is in Brazil, where large incentives drove an investment frenzy, thereby
creating massive excess capacity in the industry (Exhibit 14). This had the
impact of reducing productivity substantially. While it is true that this
overcapacity is likely to have increased competitive pressure somewhat, its
positive impact is overshadowed by its large negative impact on productivity.
In addition, the government incentives adversely affected the value creation
potential of FDI by reducing the performance pressure on companies and by
giving away money when not necessary.
Import tariffs. Import barriers in low demand segments force OEMs to set
up subscale plants (i.e, market size is not large enough to support an at
scale plant; in the absence of regulation, most OEMs would opt to import
cars assembled in their overseas plants) and thus drive down the overall
productivity of the industry. Such subscale operations in larger car segments
in India3 explain why the positive impact of FDI was roughly halved due to
scale issues.
Licensing restrictions as a barrier to competition. In addition to contributing
much needed capital and technology, FDI's crucial contribution to the auto
sector is seen in removing market distortions and unleashing competitive
3.

Because of high taxes on medium large and luxury cars, demand for these products was
suppressed and plants were underutilized.

14

Exhibit 11

DEGREE OF GLOBALIZATION OF OEMs IN 2002


Production outside home region
Percent
100
Outsourcers
Global players
90

80

OEMs vary greatly

70

in their share of
production and
sales outside the
home region

60
Suzuki

50

Regional players
Ford
DaimlerChrysler* GM
VW
Fiat
BMW

40
30
20

Renault

10

PSA

Honda
Nissan

Exporters

Mitsubishi

But there are no


companies who
produce abroad
mainly to sell to
their home region

Toyota
Fuji

Hyundai

Mazda

Porsche

0
20
40
Sales outside home region
Percent

60

80

100

* Excludes Western Europe sales from home region


Note: Based on units produced/sold. Home region defined as home continent of firms, except for Japanese & Korean
region is defined as Japan and Korea
Source: Global Insight; McKinsey analysis

firms where home

Exhibit 12

LIGHT VEHICLE PRODUCTION SHARES OF OEM GROUPS 2002


Percent
Group

Members

The Americans

General Motors
Ford
DaimlerChrysler

The Europeans

The East Asians

North America

Europe
76

Volkswagen
PSA
Fiat
BMW
Renault-Nissan

28

Toyota
Honda
Suzuki
Hyundai

14

Total production
Million units

16

16

29

68

30

18
13

Observations
Within the Triad, the majority of production is done by local firms
In non-Triad countries, production is spread evenly across groups

* Figures for Renault-Nissan


Source: DRI WEFA; McKinsey analysis

24

12*

19

Non-Triad

60

Others

Japan-Korea

15

Exhibit 13

THE AUTO VALUE CHAIN HAS NOT DISAGGREGATED FULLY

R&D

Marketing

Component
production

Final
assembly

Distribution
and service

Financing

Company
level

Headquarters

Country
level

Host country

Source: Interviews; McKinsey analysis

Exhibit 14
Brazil

REASONS FOR LARGE CAPACITY BUILDUP, 1995-2001


Thousand units

3,000

340
380
1,800

1995
capacity

480

Capacity growth
was 250% what
would have been
expected under
long-term trends

The bulk of the

Investments
based on
long-term
growth
trends

Additional
investments,
due to great
expectations
for future
growth

2001
Residual
investments, capacity
due to
incentives,
sweeteners,
and the race
to grow

additional buildup
came from great
expectations in
the economy at
large; the rest
was due to policy
incentives and
OEM strategies

Note: Effect of long-term growth trends and high expectations for future growth trends are estimated using GDP
elasticity 1.91, based on data from 1982-1995. All other factors (incentives, etc.) are included in the residual
Source: Team analysis

16

dynamics in otherwise monopolistic markets. The introduction of greater


competition leads to local managerial innovation and operational
improvement, ultimately increasing the productivity of the incumbents even
where direct transfer of technology or capital from FDI is limited. This is the
key reason why FDI had such a strong impact on productivity in India
(exhibits 15 and 16), while in China (where the government has constrained
new entrant supply and therefore competition) its impact has been only
moderate (exhibits 17 and 18). Although the industry is competitive in
Brazil, FDI's positive impact has been overshadowed by the issues of
overcapacity discussed earlier and has been further exacerbated by the
negative effects of macro-economic instability on demand.
Capital-labor trade-offs. One area where the impact of increased
competition is very evident is that of innovation: OEMs are being forced
to innovate in developing markets due the competitive pressures. There
is tremendous value creation potential to reengineer operations in low
wage environments and leverage the inverted cost of labor to capital.
However, our cases show that only in markets where competition is very
intense do managers pull this important lever. Most managers are riskaverse and prefer sticking to proven templates. For example, in India,
where competition is intense (small car segments) we found OEMs
making intelligent labor-capital trade-offs to improve performance
(exhibits 19 and 20). While in larger car segments where competition is
not so intense, firms routinely operate with levels of capital intensity
comparable to those of western plants (Exhibit 21).
Government actions that distort demand. Government regulation can also
impact demand by imposing requirements for local content and through
taxation regime.
Local content requirement. Government actions to regulate the localization
of components have forced OEMs to set up subscale component
manufacturing facilities in certain countries. Such operations have resulted
in low productivity. This ultimately leads to automobiles being sold at higher
prices and, therefore, leads to suppressed demand. This reduced market
size, in turn, impacts the productivity of the assembly sector by encouraging
subscale assembly operations and/or overcapacity. For example, local
content requirements in India and China have created relatively small-scale
manufacturing plants in the components industry. This has led to higher
components costs4 (Exhibit 22).

4.

We found it difficult to make a convincing case that local content requirements led to the
development of a mature components industry in India. Our research shows that while local
content requirements may have marginally accelerated the development of India's component
industry, it should not be seen as a direct result of these requirements. OEMs believe that they
would have sourced components locally in any case because: 1) Given India's poor
transportation infrastructure (ports, highways, rail freight) local sourcing was the only option to
leverage Just-In-Time. Importing components would have been virtually impossible and
increased costs prohibitively. 2) Following the Rupee's devaluation in the late 1980s and early
1990s, OEMs were forced to start sourcing components locally. If they had not they would have
been driven out of business by the rising costs of imports (as happened in the LCV segment).
3) Given India's cheap, technically trained labor, it also makes organizational sense to
manufacture components locally.

17

Exhibit 15
India

LIBERALIZATIONS MOST CRUCIAL IMPACT WAS TO


INDUCE COMPETITION
Labor productivity
Equivalent cars per equivalent employee; indexed to 1992-93 (100)
PAL produced 15,000 cars* and
employed 10,000 employees* while
Maruti produced 122,000 cars* with
4000 employees* in 1992-93

Increased automation,
innovations in OFT and
supplier-related initiatives
drove improvement

Less productive than Maruti


mainly due to lower scale and
utilization (~75% of the gap)

84

356

156

Increase primarily
driven by indirect
impact of FDI that
increased
competition and
forced improvements
at Maruti

144
100

38

Productivity in Improve1992-93
ments at
HM

Improvements at
Maruti

Entry of
new
players

Exit of PAL

Indirect impact of FDI


driven by competition

Productivity in
1999-00

Direct impact
of FDI

* Actual cars and employment (not adjusted)


Source: McKinsey Global Institute

Exhibit 16

MARUTIS PRODUCTIVITY CONTINUED TO GROW RAPIDLY WITH THE


ENTRY OF FDI
Cars produced per employee
Units

9)
199
94(19

FDI allowed

%
10
GR 63
CA

56
)
9
990
GR
6-1
CA
198
(
%
1
1
GR
CA

23

26

29

31

)
994
0-1
199
%(

30

70

63
58

43

38
32

1986- 1987- 1988- 1990- 1991- 1992- 1993- 1994- 1995- 1996- 1997- 1998- 199991
87
88
89
92
93
94
95
96
97
98
99
2000
* Total output/total employment (direct + indirect)
Source: McKinsey Global Institute

18

Exhibit 17
China

CHINAS AUTO INDUSTRY IS HEAVILY REGULATED,


LEADING TO LOW COMPETITION AND HIGH PRICES

ROUGH ESTIMATE

Comparison of China and U.S. passenger vehicle prices


Percent

170

10

160
20-25
10-20
0-5

100

20-30
-5-10

Actual
price in
China

Additional List price


taxes and in China
fees

Value
added
tax in
China

Difference
in profits

Difference
in cost
of components

Higher
Inventory
costs

Lower
labor
costs

Chinese cars
are more
expensive
mainly due
to higher
profit
margins in
OEMs and
suppliers

Price in
U.S.

Source: Interviews; McKinsey Global Institute

Exhibit 18
China

SUPPLY AND DEMAND IN CHINA AUTO SECTOR, 2001

ROUGH ESTIMATES

Price
$ Thousands
20.0
17.5
(1,100, 16.1)
15.0

Dead
weight
loss

Due to constrained

Excess profits*

World
price

12.5

(1,500, 11.0)
10.0

World profit level

Demand

7.5
Unmet
demand

5.0
2.5
0.0
0

200

400

600

Supply curve
* Includes excess profits of parts makers
Source: UBS Warburg; McKinsey analysis

800

1,000

1,200

Sales units

1,400

1,600

1,800

supply and tariff


protection unmet
demand is ~400,000
units (not including
income effects
in future)
Deadweight loss
is approximately
$900 million
Excess profits*
are $3 billion

19

Exhibit 19
India

MOST INDIAN PLAYERS EMPLOY LOWER LEVELS OF AUTOMATION


Shop

Best practice
level of
automation

Observed
in India

Activities, which
can be automated

Press

90-100

75-90

Loading of presses
Changing of dies

Body

90-100

0-40

Paint

Assembly

Production related
activities

70-80

10-15

15-20

20-60

<1

<1

Share of total
employment*

Welding
Clamping
Material handling

17

Priming
Base and top coat
Sealing
Material handling

14

Windscreen
Seats
Tires
Axles
Etc

33

Material handling
(transport of parts to
the line)

31

Total

100

* Based on sample of companies covering 93% of total production in 1999-00


Source: Interviews; McKinsey Automotive Practice

Exhibit 20

COMPETITION IS THE KEY DRIVER FOR AUTO OEMs OPTIMIZING


CAPITAL/LABOR TRADE-OFFS IN EMERGING MARKETS
Conditions under which . . .
Primary levers OEMs pull them

Reduce cost by
making capital/
labor trade-offs
within each
component

India small car segments China all segments


Maintain
When competitive intensity When competitive intensity is low,
automation
is high, and volumes
managers have little incentive to
by developing
justify automation, OEMs
innovate
cheaper
innovate by deploying
indigenous
indigenous technology,
technology
e.g., Maruti has developed
robots at 10% of the cost
of Suzuki

Increase
shift
utilization

Reduce
capital input

Source: McKinsey Global Institute

Utilize
standardized
capital
inputs more
intensively

China all segments


When competitive intensity is low,
managers have little incentive to
innovate and risk deviating from
standardized templates
India all segments
When labor laws are excessive
they create a perverse incentive to
reduce labor inputs, e.g., Maruti
All OEMs
When there are physical limitation,
or when reduced automation has
adverse impact on quality, e.g.,
paint shop

Reduce
automation
by substituting
fixed capital
with more
labor

Reduce cost by
leveraging
labor-capital
cost differential
in cross-border
production

Disaggregate the
value chain to
distribute
components in
optimal locations
globally (e.g.,
components)

India small car


segments
When competitive
intensity is high, OEMs
are forced to innovate to
achieve higher TFP by
optimizing labor-capital
inputs, e.g., Maruti, Telco

OEMs ignore them

All OEMs
Best practice suggests
minimizing downtime
and maximizing shift
utilization

India and Brazil

When industry is suffering from a


capacity glut there is no value in
increasing shift utilization, e.g.,
India large car segments; Brazil

20

Exhibit 21
China

CHINESE PLANTS ARE JUST AS CAPITAL INTENSIVE AS U.S. PLANTS


Investment per unit/capacity
Dollars

4,500

China JV
U.S.
equivalent

Capacity utilization
Percent

100

China JV
U.S.
equivalent

3,600

Investment per car


Dollars

76

China JV

4,500

U.S.
equivalent

4,5004,800

Reason for higher investment per unit capacity in China


Higher installation
costs

Shipping equipment

to China
Expatriate staff to
install equipment
More support
equipment
(e.g., stable power
supplies)

Smaller scale
plants

Lower line speeds

Less automation
in welding

Chinese automation

set by capacity
bottle-necks (such
as paint shops)
Similar investment in
paint shops for less
capacity
(low scale effects)

levels = 30%
compared to 90% or
more in developed
countries

Higher investment
cost per unit
capacity

New plants in China


have higher investment per unit
capacity though
roughly equivalent
actual levels, given
higher capacity
utilization

Source: UBS Warburg; plant visits; McKinsey Global Institute

Exhibit 22

LOCAL CONTENT REQUIREMENTS CREATE LOSS TO CONSUMERS


THAT NORMALLY OFFSET LABOR SURPLUS BY A WIDE MARGIN
India automotive industry

ILLUSTRATIVE

Price
Dollars

510,000

Automobile
price with
components
sourced
locally

8,400

Automobile
price with
components
sourced
globally

7,000

Average
annual wage
through
localization
requirement
Average
annual
opportunity
wage

20 % price
increase

Deadweight
loss

2x

250,000

Unmet
demand

Host
country
demand
curve
Employment
level in
components

3,100
203% wage
increase
1,524

250,000
Employment in
components
* With a 20% price decline and a price elasticity of demand of 1.5
Source: Interviews; CRIS-INFAC; McKinsey Global Institute

500,000

650,000

Annual sales Projected sales*

Quantity

Employment
necessary to
compensate
for loss to
consumers

21

Domestic taxes. Similarly, high domestic taxes lead to higher overall costs
and, therefore, to reduced demand. High taxes can therefore further
exacerbate an already small market size and prevent OEMs from achieving
the scale necessary for best-practice scale operations. For example, India's
auto sector could increase its productivity appreciably if it could eliminate
subscale assembly in larger car segments. Currently, this problem is driven
in part by insufficient demand, a demand that is suppressed by high taxes.
OEM actions. A large portion of the variable impact FDI created across the
four cases could be traced to the poor judgment of OEMs in anticipating
demand. For example, in Brazil and in India (larger car segments) OEMs
overestimated demand substantially, thus creating large overcapacity that has
dragged the overall industry productivity downwards.
Macro-economic conditions. Finally, country level macro-economic
conditions have also affected FDI's potential impact in the four cases. For
example, macro-economic instability in Brazil played a significant role in
reducing the purchasing power of Brazilians and in reducing the demand for
automobiles. As a result, the Brazilian auto industry suffered from further
overcapacity and a lowering of the sector's productivity.

22

Brazil Auto Sector


Summary
EXECUTIVE SUMMARY
The Brazilian auto sector has consisted exclusively of international companies
since Gurgel, the last Brazilian light vehicle maker exited in the early 1990s. Four
veterans VW, Fiat, GM, and Ford dominate domestic sales, but newcomers
such as Renault and Peugeot have captured a small but growing share of the
market after the liberalization of the early 1990s. The focus period for our analysis
is the Auto Regime of 1995 to the present, when government reestablished tariffs
on vehicle imports and created a range of incentives to encourage more local
production. FDI has therefore been market-seeking and is motivated largely by
trying to overcome the high import tariffs (tariff-jumping).
Overall, FDI has had a positive impact on the Brazilian auto sector during this
period. OEMs made productivity-improving investments in automation in old
plants and built new plants. Increased competition led to declining prices for
consumers. However, capacity expanded very rapidly during this period as a result
of over-optimistic market projections and very high state subsidies to investments
(that reduced the marginal cost of additional capacity). The steep macroeconomic
downturn of 1997 led to a 36 percent decline in sales by 1999 and overall sector
performance plummeted, as output, employment, and productivity declined.
Despite growth in auto exports to the U.S., Mexico, and elsewhere, the volume of
production has not yet returned to the level of 1997.
Brazil's vehicle consumers benefited from the new wave of FDI and the import
liberalization reforms despite the sector downturn, as car prices have declined
more rapidly than in the rest of the world. The costs from over-investments have
been borne by the OEMs and the public sector. States that offered large incentives
which often amounted to several hundred thousand dollars for each new job
created have been the biggest losers from the investment boom. OEMs have
suffered very weak financial performance and have not turned a profit from the
latest round of capacity expansions in either the old or the new plants.
SECTOR OVERVIEW
Sector overview. Brazil is the tenth largest vehicle-producing nation today,
with a volume of 1.7 million units in 2002. Production is focused on smaller
cars, and 75 percent is destined for the domestic market.
Domestic vehicle sales grew to a peak of 1.9 million in 1997 and then
plunged in the late 1990s (Exhibit 1). Demand jumped in the early 1990s
partly due to 1L car incentives; as a result, OEMs focused more on meeting
domestic demand, rather than on building cars for export.
In 2002, 24 percent of vehicle production was for export. This is barely
changed from the 1990 level of 22 percent. Although imports are small,
they are of high value, resulting in a trade balance close to zero (Exhibit 2).
Four veterans VW, Fiat, GM, and Ford dominate domestic sales, but
newcomers such as Renault and Peugeot have captured a small but growing
share of the market (Exhibit 3). There are domestic makers of trucks and
buses, but the last Brazilian maker of automobiles, Gurgel, exited in the
early 1990s.

23

24

Exhibit 1

AUTO SALES IN BRAZIL*


Thousand units

Plano Real

1,728 1,731
57
76

1,396
65
1,132 203
Truck/bus
50
178
LCV

245

303

1,535
70

268

253

1,407 1,406

1994

1,257
61
184

1,212
1,012

904

1993

1,489
85

1995

1996

1,588
90
216

227

1,488
83
175

3.1
5.8
-0.2

1,570

1,128

Passenger
car

CAGR
1993-2002
Percent

Sales fell by 36%


from 1997-99*

1,943
70

1997

1998

1999

1,177

1,295 1,230

2000

2001

Demand crashed
due to high interest
rates, a general
recession in 1998
and a large
devaluation in
1999. It has yet to
fully recover to
mid-1990s levels

3.5

2002

* Compare this to the biggest drop in the U.S. of 32% over 1978-82; biggest 2-year drop was 24%
Note: Figures include total domestic sales (including imports)
Source: Anfavea

Exhibit 2

LIGHT VEHICLE TRADE BALANCE, 1990-2001

Thousand units

2000 U.S. $ Millions

500

5,700

400

4,700

300

3,700
2,700

200

1,700
100
700
0

-300

-100
-200
1990

2000 U.S. $ Millions


Thousand units

-1,300

In 1995, the government


instituted an Automotive
Regime to redress the
increasingly negative trade
balance

Despite positive trade balance


in units, the higher price of
imports relative to exports
meant that the negative trade
balance persisted

-2,300
1995

2000

Note: Does not include trade in heavy vehicles or automotive parts. Data for 2002 are preliminary from Banco
Central
Source: Anfavea; Lafis

25

Exhibit 3

MARKET SHARE OF KEY PLAYERS


Thousand units, Percent
100% = 1,652
Others*

1,674

1,873

1,465

14

12

1,196

23

11

1,404

1,511

4
4

22

21

21

24

24

8
5

1,405

5
4

GM is catching up with

Fiat and VW, and the


three are battling for
market leadership

23

24

Ford was left with a bad

24

product portfolio after


its joint venture with VW
was dissolved; in
addition, 1995
regulatory changes hit
Ford heavily (since
Ford had been focusing
on imports)

29

28

30

28

28

27

29
25

Of the new entrants,


36

35

31

30

32

1995
1996
1997
1998
1999
Note: Includes light vehicles only
* Others include DaimlerChrysler, Toyota, and Honda
Source: Anfavea

30

29

2000

2001

Renault and PSA


have been most
successful in growing
their market share

25

2002

Exhibit 4

OEM ENTRY INTO BRAZILIAN AUTO MARKET

Sales

Volkswagen
Ford

Lifting of import restrictions in


1991 caused a surge of
imports from new OEMs

GM
Toyota

Honda
Land Rover
Volvo
Mitsubishi
DaimlerChrysler

Fiat

Nissan
PSA
Renault

1950s

Production

1960s

Toyota
GM
Ford
Volkswagen

1970s

1980s

Fiat
Government incentives to produce locally
led most of the new OEMs to build plants in
Brazil in the late 1990s

1990s

2000s

Honda

PSA

Mitsubishi

DaimlerChrysler
Renault
Land Rover

Source: Anfavea

26

FDI Overview. Light vehible assembly in Brazil has been almost exclusively the
province of foreign companies for decades. FDI has been mainly marketseeking (and driven in part by trade barriers), but with the aim of serving not
just Brazil but the rest of the South American market as well. Our focus is on
the period during the Auto Regime, established in late 1995, when a wave of
new FDI ("incremental FDI") entered the auto sector. To calibrate the impact of
FDI, we have chosen to compare this period with the previous period of sector
liberalization ("mature FDI").
Mature FDI (1990-95). For many years the major companies in Brazil's auto
sector Fiat, GM, Ford, and VW were protected from competition by import
barriers and price controls. But in 1990, Brazil allowed imports and price
competition and began steadily lowering tariffs. This change in policy led to
a flood of new importers (Exhibit 4), and veteran OEMs had to improve in
order to stay competitive.
Incremental FDI (1995-2000). In 1995 Brazil changed course, establishing
a measure of protection for domestic companies and creating a range of
incentives to encourage more direct investment, rather than imports.
Veteran OEMs responded by building new plants and by making upgrades at
existing ones. A few newcomers also built domestic plants. In all, OEMs
invested $12 billion in vehicle assembly during this period (Exhibit 5).
External factors driving the level of FDI. Economic growth and government
incentives created the motives to invest in Brazil's auto sector (Exhibit 6).
Country-specific factors. Investment was driven by strong macroeconomic
performance and the expectations of future growth. Additionally, Brazil's
federal and state governments also created special incentives and other
market interventions to encourage further investment.
Macroeconomic factors. Strong GDP growth and price stability of the
Plano Real helped fuel the new wave of FDI in the auto sector.
Forecasters had predicted 3.5 percent GDP growth during the period
1995-2001, but OEMs built capacity to meet GDP growth closer to
4.6 percent (Exhibit 7). Capacity was increased much more rapidly than
might have been expected based on long-term growth trends (Exhibit 8).
Government policies. Reduced taxes on 1L cars helped grow the market
at the low end, and an overall reduction in the vehicle tax fuelled high
sales growth during 1993-94. The Auto Regime gave favored tariff status
to domestic producers; this two-tiered tariff created an incentive for
international OEMs to invest locally (Exhibit 9). Finally, in an effort to
attract new auto plants to their district, states offered land, infrastructure,
tax breaks, and financing (Exhibit 10). This combination of government
interventions encouraged firms to build even more capacity than can be
explained by optimism about the economy (Exhibit 11). International
OEMs raced to Brazil to build production facilities or increase their
capacity with the hope of reaping lucrative profits from selling in the local
Brazilian market.

27

Exhibit 5

INVESTMENT IN BRAZIL VEHICLE ASSEMBLY, 1980-2001


2001 U.S. $ Millions
2,359

2,335
2,092
1,791

1,694

1,750
1,651

1,195

790
645
530

489

373

478

526

580

85

86

87

572

602

88

89

880

908

886

91

92

93

293

n/a
1980

81

82

83

84

1990

Liberalization
Competition from
higher-quality imports
Upgrade of local
production facilities
necessary
Strong increase in
demand led to
undercapacity

Stagnation
Low investment because slow
market and protectionist policies
gave little incentive to upgrade
Persistence of poor quality cars
with few special features
No chances of strong export
performance/ integration into
OEMs global production system

94

95

96

97

Overheating
Huge levels of
investment due to
Optimistic growth
expectations
Under capacity
Government
incentives
Government
sweeteners

98

1999 2000

01

02

Capacity glut
General recession
leading to decline
in sales
High overcapacity,
resulting in large
losses for OEMs

Source: Anfavea

Exhibit 6

DRIVERS OF CAPACITY BUILDUP IN BRAZIL LIGHT VEHICLE ASSEMBLY


External factors
Macro economy
Real Plan in 1994 created price
stability and helped ensure strong
GDP growth until late 1997
Popular cars
Government promoted 1L cars
through reduced tax rates
1L car taxes were particularly low in
1993-94, and sales growth was
especially high in those years
Auto Regime

Two-tiered tariff aimed at boosting


current account made production
more attractive relative to imports
Local content and trade surplus
requirements also shifted the
balance in favor of local production
Sweeteners
States offered land, infrastructure,
reduced and deferred taxes, and lowrate financing to lure new plants
Tough competition developed between
states to attract OEMs, leading to
larger sweeteners and fiscal wars
Competitive intensity

Competition from imports encouraged


OEMs to upgrade their models and
plants in order to stay competitive

Drivers
Little spare capacity
As production grew at 12% per year, capacity
began to approach full utilization
Spare capacity was only 15% in 1995, and by
1997 it had fallen to 7% (compared to 20-30%
world standard over a full business cycle)

Outcome

Capacity
Thousand units per year

Great expectations
Solid economic growth and strong vehicle
sales growth led to optimistic projections
Some analysts predicted sales would reach
3 million units by 2000
Reduced investment costs
Sweeteners both reduced overall cost, and
discounted cost of future cash payments
OEMs were also drawn to rural areas by
abundant labor and easier logistics
Entry of new players
Auto Regime incentives encouraged importers
to undertake local vehicle production
Brazil was to be used as the platform for
exports to Mercosur and rest of Latin America
Race to grow
OEMs needed new capacity to meet rising
demand and hold on to market share in an
increasingly competitive market
Each investment put more pressure on the
others to invest, leading to a multiplier effect

Source: Anfavea; CSM Worldwide; Lafis; team analysis

3,000
2,530
1,850

2,000

1995 1997 1999 2001

28

Exhibit 7

LIGHT VEHICLE PRODUCTION IN 2001 UNDER


FOUR SCENARIOS FOR GDP GROWTH, 1995-2001
Thousand units
Production under alternate scenarios for GDP growth*

2799

3000

Production failed

2548

to meet the level


that would have
been predicted
based on actual
GDP growth

2254
1946

1711

In any case, auto


companies built
more capacity
than should have
been expected,
based forecasts
at the time
Production
capacity

GDP growth
Actual
production scenario
Percent
Rationale

2.1

3.5

Actual GDP
growth for
the period

4.6

Consensus
forecast in
1995

5.5

High
enough to
explain the
capacity
buildup

Implied by
optimistic
forecasts of
vehicle sales

* Using a GDP elasticity of 1.91, based on development of GDP and production over 1982-1995
Source:Brazil Central Bank, Goldstein

Exhibit 8

AUTOMOTIVE REGIME EXPECTATIONS AND DISAPPOINTMENT


Production, thousand units per year
3,000

Expected*
2,500

Long-term
trend**

2,000

Actual
1,500

1,000

Auto
companies
built new
capacity
expecting the
strong growth
of the early
1990s to
continue

Actual
demand fell
far short of
expectations

500

0
1982 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 2000 01

Growth
Percent
CAGR
Percent

Stagnation
5.6

Liberalization
20.0

Overheating
94.9

Capacity glut
-13.8

0.7

9.6

14.3

-3.6

* Implicit growth expectations if the OEMs were trying to maintain spare capacity of 15% (the level in 1995)
** Based on average market growth from 1982 to 1995
Source: Anfavea; Banco Central; team analysis

29

Exhibit 9

IMPORT TARIFFS FOR VEHICLES*


Percent
Newly elected president
Soaring imports
Trade deficit and Mexican crisis led to
measures to reduce imports
90

Automotive import tariff


for non-local players

80
70

The two-tiered
tariff after
1996 created
an incentive
for importers
to build
domestic
plants

60
50
40
30
20

Automotive import tariff for


local players**

10
0
90
1990

91

92

93

94

95

96

97

98

99

00
2000

* Published schedule of tariff reductions


** Only companies with confirmed investments (either expansions or new facilities). Local players have to maintain
a zero or positive company trade balance to benefit from the lower tariffs. Newcomers will have to export enough
to make up for those benefits within 3 years
Source: Anfavea; Banco Central do Brasil; Conjuntura Econmica; Suma Econmica; Dinheiro Vivo; press clippings

Exhibit 10

COSTS AND EXPECTED BENEFITS OF SWEETENERS FROM STATES


Sweeteners type

Description

Examples

Land

State and municipality donate

Parana donated 2.5 million square

most or all of the needed land


Infrastructure

State provides roads and utilities,


and in some cases rail links and
port terminals

Tax breaks

State reduces or defers taxes for


no less than 10 years

Loans and financing

State provides loans at rates well


below those of the Brazil credit
market repayable in the local
currency

meters for Renaults new auto


plants
Rio Grande do Sul agreed to
provide utilities, sanitation, and
roads, and to subsidize water,
electricity, gas, telecoms, and
sewage disposal
Bahia gave Ford complete
exemption from the ICMS, ISS, and
import tax for 10 years

Paranas loans (up to $100 million)


were to be repaid in 10 years
without interest, or clause regarding
currency devaluations

Benefit type

Description

Examples

Direct jobs created

Car maker promises to create a

Renault and Mercedes both

specified number of new jobs at


autoplant
Supply of capital

Car maker commits to a minimum


capital investment

Spillovers to other
industries

State expects that auto plants will

Guaranteed long-term
presence

Car maker promises to pay a

Source: JURR

naturally attract parts makers and


other industries, creating many
indirect jobs

penalty if it shuts down the plant

In practice, it is
easier to measure
direct jobs created,
than to capture the
full costs of
sweeteners

committed to creating 1.500 new


jobs

Renault plant in Parana would


represent 60% of Renaults total
capital in Brazil

Rio Grande do Sul predicted 150


indirect jobs for each direct job
created by GM

Renault agreed to pay $50.5 million


if the plant were dismantled in less
than 20 years

Governments also
have political
incentives to
overstate the
benefits generated
by sweeteners
The cost-benefit
analysis is
especially likely to
be distorted when
the terms of the
incentive packages
are confidential

30

Exhibit 11

REASONS FOR THE LARGE CAPACITY BUILDUP, 1995-2001


Thousand units

3,000

Capacity growth
was 250% what
would have been
expected under
long-term trends

340
380
1,800

1995
capacity

480

The bulk of the

Investments
based on
long-term
growth
trends

2001
Residual
investments, capacity
due to
incentives,
sweeteners,
and the race
to grow

Additional
investments,
due to great
expectations
for future
growth

additional buildup
came from great
expectations in
the economy at
large; the rest
was due to policy
incentives and
OEM strategies

Note: Effect of long-term growth trends and high expectations for future growth trends are estimated using GDP
elasticity 1.91, based on data from 1982-1995. All other factors (incentives, etc.) are included in the residual
Source: Team analysis

Exhibit 12

BRAZIL VEHICLE ASSEMBLY LABOR PRODUCTIVITY, 1990-2000

CAGR

Value added
2001 U.S. $ Billions
5%
4.8

2.3 2.5 2.4

Labor productivity
2001 U.S. $ Thousands per employee
8%
46
41 39
41
29
19

33

3.1

3.6

4.3 4.0

3.8

3.4
2.7

-2%

13%

Modernization of
42

1990 91 92 93 94 95 96 97 98 99 2000

32

23 23

1%
16%

1990 91 92 93 94 95 96 97 98 99 2000

However, labor
Employment
Thousands
-3%
117
109106107107105102105

-3%

was not fully


rationalized during
the downturn, so
productivity
declined

83 85 89

-3%

1990 91 92 93 94 95 96 97 98 99 2000
Source: IBGE; ANFAVEA; team analysis

auto plants allowed


for rationalization of
employment and
improved labor
productivity

31

Exhibit 13

SOURCES OF IMPROVED LABOR PRODUCTIVITY


2001 U.S. $ Thousands per employee

9
12
46

31

42

Existing

13
7

19

1990

Capital
(old
plants)

OFT
(old
plants)

Utilization

1997

Capital
(old
plants)

OFT
(old
plants)

Key changes

Increased automation and

Capital

2000

and superior equipment, but old


plants continued to improve as well

Outsourcing, de-

New plants had better facility lay-

bottlenecking, and
continuous improvement
programs

out and external logistics; also


younger workers but old plants
also improved their operations
Capacity increased rapidly as
demand capsized. Overcapacity
was especially high at some new
plants

Rising demand outpaced

Utilization

Utilization

New plants had more automation

machine upgrades
OFT

Mix
shift to
newer
plants*

increases in capacity

plants made
steady
improvements
throughout
the decade
New plants
were superior
in every way,
but the
additional
capacity
created a
drag on
productivity
for old and
new plants
alike

Note: Old plants are those built before 1990


* Additional productivity due to new plants is weighted by the fraction of capacity in 2000 that is new
Source: Interviews; plant visits; team analysis

Exhibit 14

PRODUCTION AND EXCESS CAPACITY OF LIGHT VEHICLES, 1994-2001


Thousand vehicles per year
3,000

3,100

2,750
2,500
2,300

Total capacity

1,700

Excess capacity

200

Actual production 1,500

Utilization
Percent

1,800

1,900
162

1,283

2,125
141

1,399

1,173
799

1,213

263

1,537

Holding capacity
constant at 2002
levels, utilization
would reach the
worldwide
average of 75%:

By 2009 if

1,738

1,984
1,501

1,597

1,717

1,701

1,287

average
production
growth is 5%
(optimistic case)

By 2013 if

1994

1995

1996

1997

1998

1999

2000

2001

2002

88

75

91

93

65

51

57

57

55

average
production
growth is 3%
(realistic case)*

Worldwide industry
utilization estimated
to be 70-75%

Note: Exports are usually 20-24% of production (only 16% in 1995-1996). Capacity figures reported are for end of year.
Total capacity numbers are rough estimates, and depend on each OEMs assumptions about shift lengths, etc.
* Realistic case is based on average sales growth figures for 1993-2002. Optimistic case assumes 2% additional
growth, due to domestic market recovery and/or increasing exports
Source: Anfavea; CSM Worldwide; Lafis; Just-auto.com; McKinsey analysis

32

Initial sector conditions. The sector's competitive intensity was already high
at the start of our focus period, due to import competition, though the gap
with best practice operations remained significant. These factors combined
to cause OEMs to invest in upgrading their vehicle quality and manufacturing
operations.
FDI IMPACT ON HOST COUNTRY
Economic impact. From 1990 to 1997 labor productivity grew at 13.5
percent per year, and vehicle unit output grew at 13 percent a year.
Employment in the sector declined steadily. A recession in 1998-99 dragged
down both output and employment, and despite significant operational
changes that increased potential productivity, resulting overcapacity have
caused productivity to be far below its potential ever since (Exhibit 12).
Sector productivity. For most of the 1990s, labor productivity rose at the old
plants (Exhibit 13). The new plants had the potential for even greater
productivity but began opening in 1997 just as the recession took hold.
As a result, much of the new capacity has remained underutilized
(Exhibit 14), and their contribution to labor productivity has been negative.
Far from leading to "convergence" with the developed countries, the new
plants actually coincided with a sharp decline in capacity utilization and, as
a result, productivity in Brazil. This contrasts with productivity in other
developing countries, which was continuing to rise steadily (as in Mexico,
China, and India). Contrasting the two periods shows that FDI's impact
depends greatly on its environment: a negative macroeconomic environment
can lead to declining productivity despite significant investments on
automation and improved organization of functions and tasks.
Sector output. Light vehicle production climbed from 0.8 million in 1990 to
nearly 1.9 million in 1997. But over the period 1997-99 GDP growth was
zero, sales plummeted by 36 percent, and output fell by the same
proportion (Exhibit 14). In both 2001 and 2002 output was 1.7 million
units still 14 percent down from its peak. Sector growth has been driven
by economic fluctuations, rather than by changes in the level of FDI. This
conclusion is strengthened by the fact that OEMs were unable to shift to
more exports when the domestic market took a dive.
Sector employment. Employment drifted downward as productivity gains
outpaced rising output needs. In 1998 vehicle assemblers reduced their
workforce by 21 percent (22 thousand workers). After that employment
began to recover but by 2002 it had fallen to its lowest level yet: just 82
thousand workers. Again, employment levels were driven by fluctuations in
the macroeconomic environment; government incentives that were
conditional on FDI and on job creation at specific sites had little impact on
the overall level of employment in the sector.
Supplier spillovers. Liberalization and new investment in vehicle assembly
have led to significant structural changes in components manufacture, but
this areas has seen less productivity growth than vehicle assembly.

33

Exhibit 15

BRAZIL AUTO PARTS LABOR PRODUCTIVITY, 1990-2000

CAGR

Value added
2001 U.S. $ Billions

4.8

4.4
3.7

18

20

22

24

4.3 4.4

4.1

4.5
3.9

3.5

-2%

Labor productivity
2001 U.S. $ Thousands per employee
5%

0%
5.2 5.1

3%

Auto parts

1990 91 92 93 94 95 96 97 98 99 2000

27
22 23 23 21

productivity
increased as
foreign capital
entered the sector

Value added

15 15

declined in the late


1990s as OEMs
began sourcing
globally, but began
to recover after the
devaluation of 1999
made domestic
parts less costly

2%
9%

Employment
Thousands
-5%
285
255
236 237
231
214 200
192
174167170

1990 91 92 93 94 95 96 97 98 99 2000

-6%

-4%

1990 91 92 93 94 95 96 97 98 99 2000
Source: IBGE; Sindipecas; team analysis

Exhibit 16

IMPROVEMENTS AT SUPPLIERS WHO WERE ACQUIRED BY MNCs


DISGUISED
EXAMPLE

Employment declined while output


increased . . .

. . . and quality steadily improved


Percent

160% increase in
labor productivity

0.40

4,000
0.30

3,000

2,000

Employees
Output*

1,000

0
1996

1998

* 1996 output = 1000


Source: Interviews

2000

2002

0.20

0.10

0.02
0.00
1996

Customer
rejection
rate
1998

2000

2002

34

When local vehicle makers demanded better quality components at


competitive prices, many suppliers were forced out of business or were
acquired by international companies. International ownership rose from
50 percent to 80 percent between 1994 and 2001.
Foreign components companies brought new capital and better practices
to Brazil; quality improved and labor productivity rose by 6 percent per
year mainly derived from a steady decline in employment (Exhibit 15).
The most dramatic improvements in productivity were seen in the
domestic component manufacturers acquired by international companies
(Exhibit 16).
Distribution of FDI impact. Companies and the government both suffered as
a result of the resources poured into excessive capacity build-up; workers also
suffered a sharp decline in employment when the recession hit. The great
beneficiaries were consumers, but even here most of the benefits seem to
have derived from the earlier liberalization reforms, rather than from FDI per se.
Companies. Margins of veteran OEMs declined throughout the early-to-mid
1990s due to import competition. The margins of both the veterans and the
newcomers were sharply negative after the recession struck (Exhibit 17).
The OEMs have seen low margins globally for many years, but the negative
margins suffered in Brazil were exceptional by any standard. (We do not
distinguish here between FDI and non-FDI companies, as all the companies
are multinational vehicle assemblers.)
Veterans. For much of the decade, the veterans' margins declined due
to import competition. They responded by making costly upgrades to old
plants and by investing in new plants. Most veterans suffered heavy
losses because of low utilization. The best performer was Fiat the only
veteran that decided not to build a new plant in Brazil but even Fiat's
margins declined as competition increased.
Newcomers. Renault did extremely poorly: not only did it launch capacity
just as the market was receding but it sourced most of its components
from overseas, so it was hit the hardest by increased input costs after the
devaluation of the Brazilian currency.
Employees. Employment declined due to rising productivity and falling
demand, and wages declined as firms shifted production to rural areas.
Level. Employment declined in the 1990s as productivity improved and
took a dive in 1998 due to the recession. Certain States gave incentives
to companies linked to the condition that the jobs that were created
would be preserved. This helped contain the employment decline within
those regions. Nevertheless, many jobs were lost elsewhere when the
market went into recession.
Wages. New plants in rural areas created sought-after manufacturing
jobs that paid well compared with jobs in the areas concerned.
Nevertheless, average wages probably declined, due to the shift to rural
areas (Exhibit 18).

35

Exhibit 17

COST OF INVESTING AT THE START OF THE DOWNTURN


Net profit margin, percent
Fiat
(veteran)

35.7

15.9
10.9

10.8

6.5

5.1

2.2

4.3
-0.2 0.3

2.7

-3.8

Renault
(newcomer)

-45

-36

-47

-29

-108

1990 91

92

93

94

95

96

97

98

Fiat saw its margins


decline as
competitive intensity
heated up in the late
1990s but by not
overinvesting in new
capacity, it avoided
big losses when the
market receded

Renault had the


misfortune of
entering Brazil just
as the recession
began and then
doubled capacity
from a level that
was already too
high. It now
hopes to break even
in 2005

99 2000 2001

Source: Balanco Anual

Exhibit 18

LABOR COST SAVINGS FOR AUTO PLANTS IN THE EXTERIOR

Annual labor cost for plant with 2,000 workers*


2001 US$ Millions

A mid-size plant
outside of the So
Paulo region saves
~$4 million per year
in labor costs alone

9.1
3.8
5.3

So Paulo
($350 per
worker per
month)

Savings

Parana
($200 per
worker per
month)

* Assuming 13 months pay (twice in December)


Source: Interviews; team analysis

Partly because of
the wage difference,
over the 1990s unit
production outside
of the So Paulo
region grew by 12%
per year, compared
with just 4% within
the region

36

Consumers. Consumers became steadily better off throughout the decade.


Price decline. Real vehicle prices declined for most of the decade
(Exhibit 19). Though prices have declined globally, the (quality-adjusted)
decline was greater in Brazil. This was due mainly to market liberalization
and increased competition, though the capacity build-up certainly added
to the competitive intensity. (The currency devaluation of 1999 also
caused prices to jump, especially among newcomers, since it raised the
cost of auto components sourced abroad.)
Product selection and quality. By the end of the decade the Brazilian
market offered many more models; quality (in terms of both accessories
and low defects) was also far better (Exhibit 20).
Government. The federal and state governments lost a great deal. States
offered incentives in the form of land, infrastructure, tax breaks, and lowinterest loans which often amounted to several hundred thousand dollars
per new job created. Such incentives were extremely generous, even when
compared with packages offered by states in the U.S. This helped to attract
OEMs to rural areas, and some regions certainly gained new employment
and a manufacturing base. On balance, however, both the vehicle assembly
sector and the auto components sector continued to lose jobs, and the
incentives amounted to a large transfer from taxpayers to the auto
companies.
MECHANISMS BY WHICH FDI ACHIEVED IMPACT
The wave of FDI that came to Brazil in the 1990s created new capacity; increased
the level of automation; brought with it the transfer of best practices in operations
and created the potential for a more substantial export base (Exhibit 21).
Operational factors. The operational impact of additional FDI, for the most
part, was to expand capacity, to increase the level of automation, and (to a
lesser extent) to improve the export potential of vehicles.
Capacity expansion. The new wave of FDI brought the capital required for
capacity expansion. Capacity increased from about 1.7 million units in
1994 to 3.0 million in 2001. This was achieved both by building new
plants, by de-bottlenecking, and by expansions of existing plants (Exhibit 6).
Automation. FDI also brought the capital needed for higher levels of
automation in welding and final assembly, as well as changes in the
organization of functions and tasks. In particular, existing and new plants
adopted lean production techniques (e.g., more flexible work roles and
working in teams) and more efficient relations with suppliers (supplier parks,
just-in-time production, modular assembly) (Exhibit 13).
Exportability.
International companies' expanded presence in Brazil,
combined with the improvements in quality and price, created the potential
for more exports. But in 1999 exports tumbled, due mainly to the
macroeconomic problems in Argentina, resulting in a collapse in exports to
the country. Though OEMs made up for the decline to some extent by selling
more to North America, they have yet to significantly alleviate their spare
capacity problem (Exhibit 22).

37

Exhibit 19

GENERAL AND VEHICLE PRICE LEVELS, 1995-2001

Consumer price index


Retail vehicle price
Wholesale vehicle price

1995 = 100

3-year
6-year CAGR
YoY
CAGR 1998-2001 change
Percent Percent
1998-99

160
7.2

6.2

4.7

140

6.1

7.2

6.0

130

4.1

7.2

7.8

150

120
110
100
90

n/a

80
1995

1996

1997

1998

1999

2000

2001

Since the start


of the Auto
Regime, vehicle
prices have
trailed the CPI

However,
vehicle prices
jumped after
devaluation
increased the
cost of imported
auto parts

2002

Notes: (1) Auto price series based on list prices, not transactions; (2) Price series is not adjusted for hedonics or for mix
changes; (3) Wholesale and retail prices are from different sources
Source: IPCA; FGV

Exhibit 20

INCREASING DIVERSITY AMONG VETERANS

1997

Number of models produced domestically

2002

1 liter cars

3
1

4
2

GM

Fiat

Ford

Variety is highest and


increasing in the
above-1L segment,
where there is more
competition from
newcomers

VW

Larger vehicles
12

11

8
6

GM

Fiat

Source: Folha de Sao Paulo

Ford

VW

38

Exhibit 21

IMPACT OF FDI ON BRAZIL LIGHT VEHICLE ASSEMBLY


Role

Dynamics

Outcome

Increase in competition
Rise in competition on quality and price due to
capacity buildup by veterans and new players
Competition was further enhanced because
foreign players wanted to establish market
share, in anticipation of future market growth

Capital

Growth through expansion among


veterans and greenfield entry by
newcomers (e.g. Renault, Peugeot)
Implementation of more capital
intensive production methods (e.g.
increased automation in welding)
Best practices
and innovation

Improvements in number and variety of


accessories and options, and in overall
quality of cars and parts
Adoption of lean manufacturing
techniques (e.g. continuous learning)
Innovations in logistics and supplier
relations (e.g. modular production)
Development of new dealer networks
Export capability

Productivity
2001 U.S. $ Thousands
per worker year

Increase in size and improved quality


Prices fell while the market grew, because
rising supply more than met the demand
OEMs adopted global platforms and models;
upgraded accessories; used better quality
parts; and achieved much lower defect rates
Changes in labor productivity
Productivity gains through greater capital
intensity and improved technologies
Additional gains from lean manufacturing
techniques and improved logistics, often
involving investments in training
Idle capacity from excessive buildup caused a
drag on labor productivity (especially following
recession and devaluation)

46
42

19

1990

1997

2001

Spillovers to parts manufacturing


Higher standards demanded by OEMs forced
suppliers to invest in new technologies
Because domestic manufacturers had limited
access to the needed capital, they gave way
to a wave of foreign acquisitions
Foreign parts companies adopted best
practices, and invested heavily in new
technologies

Global brands and access to MNC


resources and knowledge (e.g. for
financing, R&D, marketing)
Relationship with headquarters and
ability to negotiate trade contracts
with other regional OEMs
Source: McKinsey analysis

Exhibit 22

DEVELOPMENT OF BRAZILS KEY EXPORT MARKETS


Thousand units
Average price
per car, 2000
U.S. $ Thousands
All others
U.S.
Mexico
Other Europe
Italy
Other
South America

397

379
0

26
14

34

80

26

261

356

23

30

23
39
36

17

51

59
208

96

7.6
5
14

22.1

8.5
99
57

Source: ANFAVEA

6.7

82
91

1998

Recent trade

32

10

30

1997

shifted away from


Argentina and
Europe
15.7

90
33

46

236

Exports have
91

39

47

Argentina

375

1999

2000

2001

n/a
2002

11.1

agreements with
Mercosur and
Mexico have led to
increasing trade
with the rest of
Latin America

Meanwhile OEMs
are exporting to
new markets in
Turkey, South
Africa, and China
and are beginning
to reach the US

39

Exhibit 23

ECONOMIC ENVIRONMENT AND THE LIGHT VEHICLE SECTOR


Income
2-year CAGR
Percent

GDP
Light vehicle
sales
24

20
2

3 6

1993

1995

1997

1999

R$/U.S. $

Brazil
devaluation

13

-20

Exchange rates

Argentina
crisis and
terror attacks

Interest rates
2001

Vehicle sales amplify changes in GDP; when GDP


growth faltered in 1998-99, vehicle sales plummeted

In 1998-99, sales were


dragged down by falling GDP,
rising interest rates, and the
devaluation (which raised
prices and reduced exports)

1
0
95 96 97 98 99 00 01 02
Recurring devaluations since 1999
encouraged vehicle exports, but also made
auto parts more expensive, thereby raising
vehicle prices and stifling domestic sales

Real interest rate (SELIC)


Percent (annualized)
Russian
Asian
crisis
50
crisis
Brazil
30
devaluation

10
-10

Exports
Light vehicle exports, 1996-2001
Thousand units
236
195

Interest rates rose repeatedly in 199798. They declined after devaluation,


but financing fell substantially (from 40
to 24 percent of total sales)

208
91

99
45

1996

1997

1998

1999

2000

2001

Due to the financial crisis in 1999, exports to


Argentina dropped 56%, resulting in a 31% fall
in exports overall
Source: Banco Central; Anfavea; Lafis; MCM; team analysis

95 96 97 98 99 00 01 02

40

Industry dynamics. Competition was high throughout the period under review
and intensified after 1998, as a result of the increased overcapacity. However,
the key impetus for this competition was not the new wave of FDI, so much as
the liberalization reforms that preceded it.
Competition escalated during the auto regime, as the industry saw several
new entrants and reduced profit margins. After the recession struck,
competition became even more intense, as OEMs looked for ways to make
use of expensive spare capacity.
Nevertheless, an analysis of the components of competitive intensity
indicates that most of the competitive pressure was already present during
our comparison period. Moreover, the Auto Regime policies that attracted
more FDI did so by limiting the extent of import competition. Some
intensification of competition may be attributed to the new wave of FDI, but
the key factor in increasing competition was the import and price
liberalization at the start of the decade.
EXTERNAL FACTORS THAT AFFECTED THE IMPACT OF FDI
FDI's impact was enhanced by sector and price liberalization but the impact of
the incremental FDI during the period of review was seriously hampered, both by
recession and by the distorting effects of government policies.
Country-specific factors. The sharp macroeconomic downturn proved
disastrous for the impact of FDI. Government policies (incentives and reduced
tariffs and taxes) had an indirect effect by creating overcapacity.
Macroeconomic factors. The economic environment hampered the ability of
the new FDI to have greater impact. In late 1997, GDP growth collapsed.
Automobile later prices rose, due both to an increase in real interest rates
and to an increase in the cost of inputs following the devaluation of January
1999 (Exhibit 23). The result of these factors combined was a severe drop
in vehicle demand, high excess capacity, and worse performance in output,
productivity, and employment.
Government policies. Reduced tariffs enhanced the impact of mature FDI.
As Brazil steadily reduced its tariffs, competitive intensity increased,
resulting in higher productivity and better quality vehicles at lower prices.
Reduced taxes had less effect on the impact of FDI, but the focus on 1L cars
made it harder for OEMs to shift their production to export. The principal
effect of state incentives was to transfer resources from governments to
companies. By contributing to high overcapacity, incentives also added to
the poor performance in productivity and profitability of the OEMs.
Initial sector conditions. At the start of the first period under review, of
mature FDI, Brazil's auto sector was uncompetitive and highly inefficient, so it
was ripe for change. However, by the being of the second period, incremental
FDI, the sector had been transformed into a much more competitive and
productive industry and there was therefore less opportunity for incremental
FDI to have major impact.

41

SUMMARY OF FDI IMPACT


Overall, FDI had a positive impact on the Brazilian auto sector by making
productivity-improving investments and reducing prices to consumers. However,
the over-investment in capacity and subsequent economic downturn wiped out
these improvements as productivity, employment, and profits all fell. States that
offered large incentives may have been the biggest losers. Brazil's vehicle
consumers benefited most, both from the wave of incremental FDI and from the
import liberalization reforms that preceded it.

42

Exhibit 24

BRAZIL AUTO SUMMARY

1 Government liberalized imports and prices in 1990, leading to a large


influx of new players. In order to compete with imports, OEMs made great
improvements in quality and productivity. Rapid market growth for much
of the decade was followed by recession and devaluation in 1998-99.

External
factors
2
1

Industry
dynamics

FDI

2 In mid-decade Brazil stabilized prices, and created a two-tiered tariff which


favored domestic producers. State governments also offered large
sweeteners to attract new investments. These factors, combined with
market growth, attracted a flood of FDI in 1995-2000. OEMs invested
mainly for the Mercosur market, rather than as efficiency seekers.

3
3
Operational
factors

Sector
performance

3 Productivity grew rapidly, but was then marred by the demand downturn:
Competitive intensity fostered plant upgrades and operational
improvements. These, along with high utilization due to market
growth, fuelled productivity growth for much of the decade.
But new plants came on line just as vehicle demand plummeted. The
result was a two-year fall in capacity utilization and labor productivity,
and only slow recovery thereafter.
4 Overall, FDI had a positive impact in making productivity-improving
investments and reducing prices to consumers. However, the overinvestments on capacity and subsequent economic downturn muted
these improvements as productivity, employment, and profits all fell.
States that offered large sweeteners may have been the biggest losers.
Brazils vehicle consumers benefited from both the wave of increased FDI
and the import liberalization reforms that preceded it.

Exhibit 25

BRAZIL AUTO FDI OVERVIEW


FDI periods
Focus period: incremental FDI

1995-2000

Comparison period: mature FDI

1990-1995

Total FDI inflow (1995-2000)*


Annual average
Annual average as a share of sector value added

$11.9 billion
$2.0 billion
52%

Annual average as share of GDP**

0.40%

Annual average per employee

~ $22k

Entry motive (percent of total)


Market seeking
Efficiency seeking

100%
0%

Entry mode (percent of total)


Acquisitions

0%

JVs

0%

Greenfield

100%

* Includes only vehicle assembly not automotive parts


** Using 2001 GDP
Source: Anfavea, Banco Central

43

Exhibit 26

BRAZIL AUTO FDIs ECONOMIC IMPACT IN


HOST COUNTRY
Sector performance
during
Economic
impact

Mature FDI Incremental


(1990-95)
FDI (95-00)

Sector

16%

1%

FDI
impact
+

productivity
(CAGR)

++
+

Highly positive
Positive
Neutral
Negative
Highly negative
[ ] Estimate

Evidence

Productivity grew rapidly from the start of the decade, as a result of


the competitive intensity created by import and price liberalization.

OEMs improved potential productivity with state-of-the-art new plants


and plant upgrades, but the net effect was small due to the demand
downturn and indeed FDI contributed to the overcapacity

Sector output

+13%

-2%

(CAGR)

The domestic market grew rapidly in the first half of the decade. It
reached a peak in 1997, then dropped 36% in two years.

Production followed the same roller-coaster pattern. As a result, so far


the wave of incremental FDI has resulted in greatly expanded
capacity, without a corresponding growth in output

Sector

-2%

-3%

employment
(CAGR)

Employment declined in the 1990s as productivity improved.


States gave sweeteners on the condition that jobs would be created
and preserved. This helped contain the employment decline and
preserved many jobs when the market turned south

Suppliers

9%

(Labor
productivity
CAGR)

2%

Competition in vehicle assembly created pressure for suppliers to


improve their productivity as well. Suppliers also underwent a wave
of FDI in the form of acquisitions, expansions, and upgrades but
the decline in the vehicle market caused overcapacity there too, so
that the impact of FDI on labor productivity has so far been minimal

Impact on
Competitive intensity

++

The large capacity buildup combined with a stagnant market to put


enormous competitive pressure on OEMs

But much of the rise in competitive intensity (evidenced by declining profit


margins) had actually taken place earlier in the decade the result of
import and price liberalization

Exhibit 27

BRAZIL AUTO FDIs DISTRIBUTIONAL IMPACT IN


HOST COUNTRY

__
[ ]

Sector performance
during
Economic
impact

Mature FDI Incremental


(1990-95)
FDI (95-00)

++
+

FDI
impact

Evidence

Companies
FDI companies

Despite price liberalization, profit margins rose in early years as the

market grew rapidly. But OEMs suffered dramatic losses when their
large new investments coincided with a large decline in the market
Non-FDI
companies

N/A

N/A

N/A

No domestic makers of light vehicles

Employees
Level of
employment
(CAGR)
Wages

-2%

-3%

Employment declined in the 1990s as productivity improved.


States gave sweeteners on the condition that jobs would be
created and preserved. This helped contain the employment
decline; still, many jobs were lost when the market turned south

New plants in rural areas created sought-after manufacturing jobs


that paid well compared with jobs in those regions. (Nevertheless
average wages probably declined, due to the shift to rural areas)

++

Real prices declined for most of the decade, as a result of

Consumers
Prices

import and price liberalization. (But prices increased in 1999,


when devaluation raised the cost of imported parts.)
Selection

++

Selection improved as a result of import liberalization and


increasing competition

Government
Taxes/Sweeteners

Government benefited from the early growth in the industry


through higher tax revenues

Sweeteners from state governments and development banks have


been very expensive, and have so far failed to generate revenue

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

44

Exhibit 28
High due to FDI
High not due to FDI

BRAZIL AUTO COMPETITIVE INTENSITY


Sector
performance during

Low
Incremental
FDI (95-20)

Mature FDI
(1990-95)
Pressure on
profitability

Evidence

Rationale for FDI


contribution

Profit margins (for sample

Capacity buildup combined

company) began to decline after


1993, even as the market grew

Newcomers entered as
New entrants

Competitive pressure

importers; several later


built domestic plants

Weak player exits

from importers was still


significant even after
some built plants in Br.

The one domestic carmaker,

New wave of FDI led to

Gurgel, exited after import


and price liberalization

market entry, not (yet)


any important exits

Real prices declined due to


Pressure on prices

Price competition came mainly

liberalization (though they rose


after devaluation in 1999)

Newcomers took share from

Changing market
shares

Pressure on product
quality/variety

with macro factors to put


increased pressure on OEMs

from liberalization, but was


intensified by overcapacity

New entrants and large FDI

market leaders; also some


shifting among the 4 veterans

investments increased the


competition for market share

Steady increase in number of

Imports brought more variety

models; expansion of new


segments

directly, and prompted OEMs in


Brazil to increase their variety

Entry of newcomers for


production added to variety
Pressure from
upstream/downstream industries

Being few in number, OEMs


enjoyed market power relative
to both suppliers and dealers

On the whole, real prices and


Overall

profits declined as quality and


productivity were improving

Additional FDI and entry of new


players was not enough to give
power to suppliers and dealers

Competition was driven by


import and price liberalization,
and was augmented by capacity
buildup and a macro downturn

Exhibit 29

BRAZIL AUTO EXTERNAL FACTORS


EFFECT ON FDI
Level of FDI*
Global industry
Global
discontinuity
factors

Impact on
level of FDI Comments
0.40%

Impact
on per
$ impact Comments

++
O
O
O

Domestic market expansion fuelled


optimistic forecasts for the future

O
O
O
O

Macro factors
Country stability

Price stabilization under Real plan

Product market regulations


Import barriers
Preferential export access
Country Recent opening to FDI
specific
Remaining FDI restrictions
factors
Government incentives
TRIMs
Corporate governance
Taxes and other

+
+
O
O
++
+
+
+

Capital market deficiencies

Labor market deficiencies

Informality

Supplier base/
infrastructure

Competitive intensity

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

created expectations for growth

Sector
initial
conditions

++ Highly positive

Two-tiered tariff led to more plants


Zero tariff with Argentina (given a
vehicle trade balance below 6.2%)

resulted in high spare capacity for years


O
O
O
O

Large sweeteners from states

LCRs and trade-balancing reqs**

Transient managers may be myopic


O
Tax breaks on 1L cars boosted
O
demand, encouraged investment

+ (H) Import and price liberalization led


OEMs to invest in upgrades

Crash in demand and currency devaluation

Sweeteners and managers with only short


time horizons helped create overcapacity;
TRIMs boosted size not productivity of
local parts industry

O
O
O
O

+ (H)

Competition led OEMs to focus on productivity


(though the results were marred by overcapacity)

Gap meant that the new wave of FDI had


+ (M) Gap caused OEMs to invest even
+ (M)
opportunity for real impact
more in state-of-the-art new facilities
* Average annual inflow as a percentage of GDP
** Local content requirements of 60% to attract investment in parts plants; OEMs faced 125% tax on any imports in excess of exports
Gap to best practice

45

Exhibit 30

BRAZIL AUTO FDI IMPACT SUMMARY

[ ] Extrapolation ++ Highly positive

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

External Factor impact on


FDI impact on host country
Level of FDI relative to sector*

52%

Economic impact

Sector productivity
Sector output

Level of FDI
Level of FDI** relative to GDP
Global factors

+
O

Sector employment
O

Suppliers

Impact on
competitive intensity

Distributional impact
Countryspecific factors

Companies
FDI companies

Non-FDI companies

N/A

Employees
Level

Wages

Consumers
Prices
Selection

Government
Taxes

++

Per $ impact
of FDI

0.40%
O

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

++
O
O
O

O
O
O
O

Macro factors
Country stability

Product market regulations


Import barriers
Preferential export access
Recent opening to FDI
Remaining FDI restriction
Government incentives
TRIMs
Corporate governance
Taxes and other

+
+
O
O
++
+
+
+

O
O
O
O

Capital markets

Labor markets

Informality

Supplier base/
infrastructure

Global industry
discontinuity

O
O
O
O
O
O

* Average annual FDI/sector value added


** Average (sector FDI inflow/total GDP) in key era analyzed

Competitive intensity

+ (H)

+ (H)

Gap to best practice

+ (M)

+ (M)

Sector initial
conditions

46

Mexico Auto Sector


Summary
EXECUTIVE SUMMARY
The auto sector in Mexico has been entirely in the hands of international investors
for several decades. Starting in mid-1990s, FDI was efficiency-seeking and
oriented mostly to export to the U.S. Five veterans Ford, GM, Chrysler, Nissan,
and VW still control 90 percent of the market, but their previously more
protected local market was opened to competition from imports and new local
producers following the signing of NAFTA in 1994. Our analysis focuses on the
period from 1994 to the present, when the veteran players were making
incremental investments in response to the integrated North American market
and the more competitive policy environment within Mexico.
The impact of FDI on the Mexican auto sector in this period has been very positive.
Output, productivity, and employment have increased as OEMs responded to the
more competitive environment by rationalizing production across North America.
Each plant is now specialized and focused on fewer models, thereby allowing a
decrease in fixed cost expenditures and increased utilization rates. The
international companies have achieved further productivity improvements in
Mexican plants by adopting lean techniques and more efficient organization of
suppliers, reaching an average productivity level 65 percent of the U.S. level. As
a result of more diversified sales stemming from increasing exports to North
America, the sector has maintained rapid output growth, despite the 1995
financial crisis and recession in Mexico. In contrast to Brazil, Mexico has not given
away any incentives. Because output has outpaced productivity growth,
employment has increased by four percent annually. At the same time, consumer
selection has increased through access to imported models. While Mexico has a
very large auto components sector that exports a significant share of its output,
productivity growth in the components segment has been much lower than in
assembly.
There is further potential for growth and improved performance in the Mexican
auto sector and components sectors. A number of factors in the U.S. limit the
growth of Mexico's share in North American auto sector: regional overcapacity,
strong unions, and large state incentives.
SECTOR OVERVIEW
Sector overview. Mexico ranks ninth in world vehicle production, with a
volume of almost 1.8 million units in 2002. It exports much of its production
to the U.S. and Canada; in recent years, vehicle makers have normally
exported 70-80 percent of their production.
Domestic market sales (including imports) were nearly 1 million units in
2002 and have grown at nine percent annually since 1986, a sharp
downturn in 1995 notwithstanding (Exhibit 1). Production was nearly 1.8
million units in 2002, and has grown by 11 percent annually (Exhibit 2).
In 1995, exports as a share of total production jumped from 52 percent to
84 percent, and have remained high since then. In 2001, Mexico
represented 17 percent of all U.S. vehicle imports, up from eight percent in

47

48

Exhibit 1
CAGR
Cars Trucks
Total

VEHICLE SALES IN THE MEXICAN MARKET, 1986-2002


Thousand units

1994-2002
7.0 4.8
6.3

69% drop in
sales due to
currency crisis
1986-94
12.6 8.1
11.0

252

676

644 667

231
251

177

198

482

183

342 171

324

259 248 132

Cars

161

94

353
210

154

260

576 598

551

Trucks* 98

853
266

643

446

977
919

392

445

399

415

184

212

179
667

711

Despite the
sharp downturn
in 1995, annual
sales growth has
been close to
9% since the
mid-1980s

593

127
427

Most of the sales


growth has been
in cars

455

303

67

275

217

1986-2002
9.7 6.4
8.7

197
117

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

* Includes light trucks


Note: Figures include total domestic sales (including imports)
Source: AMIA

Exhibit 2
CAGR
Cars Trucks
Total

VEHICLE PRODUCTION IN MEXICO, 1986-2002


Thousand units
1994-2002
3.6 12.9
6.2

1,889
1,817

1,428

1986-94
19.4 7.7
15.7

1,211

961
804
629

341

338

Trucks*

133

112

Cars

208

226

275

220

475

1,097
240

240

609
634

499

483

932

414

232

206
1,279

190

151
721
598
354

610

1,338

1,051 1,055

505

1,493

1,774

776

835

857
700

797

855

953

994

1,208
1,140

439

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

* Includes light trucks


Source: AMIA

1986-2002
11.2 10.3
10.9
Vehicle
production
growth has
slowed since
1994, and has
declined since
2000 due to a
fall in US
demand
Product mix
under NAFTA
has shifted
toward trucks
(led by GM and
DCX)

49

1994 (Exhibit 3). However, imports into Mexico are rising at an even faster
rate, so the trade balance has narrowed in recent years, especially since the
downturn in the U.S. market since 2000 (Exhibit 4).
Five veteran players Ford, GM, Chrysler, Nissan, and VW have been in
Mexico for many decades. The 1990s saw a wave of new entrants, but
these were mostly importers; the Big Five continued to dominate both
production and sales (Exhibit 5). There are domestic makers of trucks and
buses, but no Mexican light vehicle manufacturers.
FDI overview. Light vehicle assembly in Mexico has been almost exclusively
the province of foreign companies for decades. Early FDI was market-seeking,
with the aim of overcoming trade barriers; mature FDI has been largely
efficiency-seeking, striving to serve the U.S. market. Our review focused on
period since 1994, when NAFTA was phased in and OEMs expanded capacity
(we call this period "incremental FDI"). To calibrate the impact of FDI under
NAFTA, we have chosen to compare this with the early years of the Fifth Auto
Decree, 1994-2000 (which we call "mature FDI"), when imports were
liberalized.
Mature FDI (1990-1994).
OEMs began making efficiency-seeking
investments in the 1980s and early 1990s, building several new automobile
plants outside of Mexico City (GM in Saltillo, Ford in Hermosillo, Nissan in
Aguascalientes). But the real push to reach levels of global best practice
began in 1990, when import liberalization allowed new entrants and created
a more competitive environment (Exhibit 6).
Incremental FDI (1994-2000). In the first six years that NAFTA was being
phased in, the auto sector received $9 billion in FDI. OEMs invested nearly
$4 billion, upgrading and expanding capacity at their existing plants by 50
percent. The rest came from auto components companies, in which FDI has
been concentrated on acquisitions (Exhibit 7).
External factors driving the level of FDI. Liberalization led OEMs to make
capital upgrades, while market growth in the U.S. encouraged capacity
expansion in existing plants.
Country-specific factors. The threat of imports resulting from free-trade
agreements forced OEMs to become more competitive in the local Mexican
market; they responded by upgrading their capital. Strong growth in the
U.S. market also led OEMs to expand capacity. The expansion would have
been even greater if it had not met market distortion in the U.S., those of
overcapacity, strong unions, and large state incentives (Exhibit 8).
Location. Mexico's proximity to the U.S., combined with labor costs that
are only a quarter those of the U.S. and Canada, made Mexico the
obvious choice for efficiency-seeking FDI. The level of FDI was limited by
several factors north of the border, however, high levels of excess
capacity, powerful labor unions, and large incentives from U.S. states.
Macroeconomic factors. The Tequila Crisis of 1995 hurt domestic sales,
but had no obvious impact on investment decisions, perhaps because
OEMs were able to respond by exporting more. The more relevant
macroeconomic factor has been the strong growth in the U.S., which
drove OEMs to produce at levels close to full capacity by 2000.

50

Exhibit 3

MEXICO AS AN EXPORT PLATFORM TO NORTH AMERICA


Exports rose sharply in the crisis, and have
continued growing under NAFTA

. . . especially to the US, where imports


from Mexico grew by 18% per year

Mexico vehicle production


Million units
1.1

0.9

16%
For
domestic
market

US vehicle imports
Million units
1.8

23%

48%

4.8
5%
5%
4%
12%

4.8
Other
5%
S. Korea 5%
4%
Germany
8%
Mexico

7.1
7%
8%
7%

17%
Japan

36%

30%
26%

84%
For
export

77%

52%
Canada

1994

1995

2001

42%

44%

1994

1995

35%

2001

Source: AMIA

Exhibit 4

MEXICO VEHICLE EXPORTS AND IMPORTS, 1986-2002


Thousand units

CAGR
Exports Imports
Balance

1986-2002
1600
1500

11.1

1400
1300

28.7
-5.4

1200
1100
1000
900
800
700
600

19.9 NA
15.8

1994-2002

Exports
1986-94
29.4

NA
27.2

Imports*
Balance

500
400
300
200
100
0
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

* No imports before 1990


Source: AMIA

The vehicle trade


balance has grown
more slowly since
1994
Export growth
has slowed
Imports are
growing rapidly
Nearly 90% of
exports are for the
US; exports have
fallen since 2000
due to a downturn
in demand there

51

Exhibit 5

SHARE OF MEXICO DOMESTIC VEHICLE SALES BY OEM, 1990-2002


Thousand units, percent
Cars
Others
DCX

100% = 186
0
15

257
0
16

345
0
19

13

497 599
0
0
13
15
12
17

38

36

32

11

11

13

15

20

22

21

24

Ford

15

14

15

VW

38

38

GM

R/N

23

424
0
15

636
0
18

592
1
13

674 930

863

763

13

591
2
11
10

41
10
10

5
12
11

9
13
12

10
10
12

23

25

26

27

24

21

27

25

25

23

20

22

22

25

23

21

23

25

23

27
27
16

R/N leads in

18
23

14

domestic car
sales, followed
closely by GM

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

VW has lost share

Trucks

Others

100% = 10
06

18

20
05
16

22

22

24

20

24

22

34

31

24

30

29

33

21

25

28

22

23

19

VW
R/N
DCX

44
06

47
07

18

21

70
07
17

182
3

22

339
1
14

391
1

23

36

17

381
1
17

400 504
1 3
3
18
17

17

22

20

19

31

29

29

29

28

28

31

30

31

29

33

in car sales, and


fell to third place
in 2002

541
2 3

549
44

16

17

Ford and GM lead

19

17

in domestic truck
sales

GM
Ford

26

32

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Source: AMIA

Exhibit 6

OEM ENTRY INTO MEXICO AUTO MARKET


Jaguar
Land Rover

Sales

Ford

GM

Peugeot
Audi
Porsche
Honda

Fifth Automotive
Decree liberalizes
imports

Chrysler*

Nissan** VW

Daimler-Benz

BMW

1930s

1940s

1950s

1970s

1960s

1980s

Toyota

1990s

MercedesBenz
BMW
VW

Production

GM

Chrysler

* Merged with Daimler-Benz in 1998 to become DCX


** Includes Renault since 2001
Source: AMIA

NAFTA begins
to take effect;
fully free trade
by 2004

2000s

Toyota

Daimler-Benz
Nissan**

Ford

Land
Rover
Seat

MercedesBenz

1920s

Volvo

Honda
Audi

52

Exhibit 7

FDI IN MEXICO AUTO SECTOR 1994-2002


U.S. $ Millions
Vehicle Auto
assembly parts

1,380
1303
1226

941
735
558
492 517

764

723
568

531 558

460

236

233
35

1994

1995

1996

1997

1998

FDI flows have been


very erratic from year
to year

20
1999

2000

2001

Since NAFTA took


effect in 1994, the
Mexico auto sector
has attracted over
$11 billion in FDI:
$4 billion in vehicle
assembly
$7.3 billion in auto
parts

2002

* Data for 2002 are estimates based on figures reported in September 2002
Source: Secretara de Economa

Exhibit 8

FORCES FOR AND AGAINST CAPACITY BUILDUP


FOR
Open market
Free-trade agreements created
incentives to build lines in order to
(a) compete against imports in
Mexico and (b) seize opportunities to
specialize and trade
Labor force
Mexicos wages were as little as
20% those in the US, while skill mix
was good and unions were
increasingly amenable to flexible
work teams
MNC parts makers
Regulations allowing MNCs to take
majority share of parts companies
helped to strengthen the supplier
base (primarily among first-tier
suppliers)
Normalization
Normalized regulations across
Mexican states made domestic
market more attractive
Source: Interviews, team analysis

AGAINST
Capacity
Million units per year

2.0
1.8
1.6
1.3

1995 1997 1999 2001

OEMs have expanded


capacity at existing
plants, but have so far
decided against
building new plants

Overcapacity
Excess capacity in North America
made OEMs reluctant to expand in
Mexico, despite its advantages
Organized labor
Unions in the US and Canada
fiercely resisted any relocation to
Mexico, while unions in Mexico won
wage concessions that reduced
Mexicos comparative advantage
Suppliers
Supplier base remained stronger in
the US and Canada, particularly in
tiers 2 and 3, and OEMs were
hesitant to build new plants in
Mexico unless they could fully
develop the supplier base there
Sweeteners
When OEMs did build new plants,
incentives from US and Canadian
states enticed them to stay north

53

Government policies. NAFTA and other trade agreements entailed a


reduction in tariffs and in local content requirements (exhibits 9 and 10).
Mexico also lifted the limit on foreign investment in auto components.
These reforms encouraged OEMs to upgrade their existing facilities and
to better integrate them with their North American production strategy.
Initial sector conditions. Competition had already begun to increase at the
start of the period under review due to import liberalization. At this time
many of the plants were outdated and badly in need of upgrading if they
were to compete in the North American market. This gap with best practice,
coupled with intense competition, accounts for much of the investment in
upgrading production and improving productivity.
FDI IMPACT ON HOST COUNTRY
Economic impact. The industry has grown rapidly in both sales and
production, despite a financial crisis and recession in 1995. Productivity
growth has accelerated over the 1990s and consumers have benefited as
variety has increased and prices have fallen (Exhibit 11).
Sector productivity. Labor productivity grew by nearly 11 percent a year in
the incremental FDI period, compared with seven percent a year in the
earlier period. This improvement was due both to new FDI and to
liberalization, which together facilitated several developments. These
included: specialization and rationalization across countries, high capacity
utilization due to strong U.S. economic performance, capital upgrades, and
the adoption of better operational practices. In both periods, the levels of
productivity growth compare favorably with those witnessed in other major
developing countries during the same period.
Sector output. Unit production grew at 9.5 percent a year from 19942000, while value added grew by 15 percent a year, compared to four
percent a year in the earlier period. The growth in vehicle production was
fueled by growth in both the domestic and U.S. markets. This growth would
not have been possible without the incremental FDI to expand capacity
(Exhibit 2).
Sector employment. Employment in the focus period grew by four percent
a year, compared to an annual decline of three percent in the earlier period.
Employment declined early in the decade due to rising productivity and fell
even further during the crisis of 1995. In recent years, rising production has
more than offset rising productivity, and employment has risen, though it is
still below its 1991 level (Exhibit 11).
Supplier spillovers. Liberalization of policy restrictions in vehicle assembly
led to significant structural changes in components manufacturing, though
productivity levels and growth are far lower than in seen assembly
(Exhibit 12).
When local vehicle makers demanded better quality components at
competitive prices, many suppliers were forced out of business or were
acquired by foreign companies. The majority of first-tier suppliers were
acquired by multinational companies.

54

Exhibit 9

MEXICO EXPORT REQUIREMENTS UNDER NAFTA


Tax on overimported vehicles
Percent

Value of exports as a
share of imports
Percent
120
Share

30

100

80
20
60

40

Tax

10

NAFTA
eliminated
the penalty
for excess
imports more
rapidly than
the export
requirements

20

1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 2005

Source: EGADE

Exhibit 10

DOMESTIC VS. REGIONAL CONTENT REQUIREMENTS, 1990-2005


Percent of total value added

70
NAFTA regional
content requirement
took effect in 1995

60
50
40

Vehicle
assembly
DCR

30
20
Auto parts DCR

10
0

1990 91 92 93 94 95 96 97 98 99 2000 01 02 03 04 2005


Source: EGADE

NAFTA
eliminates
Mexican
domestic
content
requirements
(DCR) but
imposes North
American
regional content
requirements

55

Exhibit 11

MEXICO VEHICLE ASSEMBLY LABOR PRODUCTIVITY, 1990-2000

CAGR

Value added
2001 U.S. $ Billions

11.8

9.3%

4.8 5.3

Labor productivity
2001 U.S. $ Thousands per employee

6.0 5.8 5.9

6.8

7.9 8.6

9.4

4.8

15.0%
4.0%

1990 91 92 93 94 95 96 97 98 99 2000
8.8%

197
154163158166

85 88

rose significantly
over the 1990s
Rising productivity
caused employment
to decline until 1996,
when demand
began to grow faster
than productivity

118115
101106

10.8%
6.8%

Employment
Thousands

1990 91 92 93 94 95 96 97 98 99 2000

57 61 60 55

Labor productivity

0.5%

50

-2.7%

42 44

49

60
54 57

3.8%

1990 91 92 93 94 95 96 97 98 99 2000
Source: INEGI; team analysis

Exhibit 12

MEXICO LABOR PRODUCTIVITY IN ASSEMBLY AND AUTO PARTS, 2000


Value added
2001 USD Billion

21.9
2.5
11.8

7.6

Productivity
2001 USD thousands per
employee

Enormous
Vehicle Doassem- mestic
bly
parts

197

Maquila Total

Employment
Thousands

38
12
Vehicle
Domeassembly stic

473

Maquila

211
60

Note: Figures are for the year 2000


Source: INEGI

202

Vehicle Doassem- mestic


bly
parts

Maquila Total

differences in
productivity reflect
technologies used
e.g., maquila
production is by
definition more
labor intensive

Gap between
vehicle assembly
and domestic parts
makers is larger
than in other
countries

56

Exhibit 13

MEXICO DOMESTIC AUTO PARTS LABOR PRODUCTIVITY, 1990-2000


Value added
2001 U.S. $ Billions

CAGR

5.3%
4.6

1.1%
37 38
34 35 35

28

4.9

4.4 4.8

5.6

6.9

7.6

4.0

9.7%

1.1%

Labor productivity
2001 U.S. $ Thousands per employee

34 33
31

5.1 5.0

6.3

1990 91 92 93 94 95 96 97 98 99 2000

31 30

-1.4%
3.7%

Employment
Thousands

1990 91 92 93 94 95 96 97 98 99 2000

Among domestic
auto parts
companies (both
national and
multinational),
there has been
robust growth in
employment and
productivity since
the crisis of 1995

4.1%
202
182188
161
153160158153
135
134143
5.8%
2.5%

Note: Numbers exclude maquila companies


Source: INEGI; team analysis

1990 91 92 93 94 95 96 97 98 99 2000

Exhibit 14

MEXICO MAQUILADORA LABOR PRODUCTIVITY, 1990-2000

CAGR

Value added
2001 U.S. $ Billions

8.0%
1.4

1.2

0.5%
13 13 13

1.5

1.7

0.9

Labor productivity
2001 U.S. $ Thousands per employee

12
11 12 11

1.2 1.3

1.9

2.1

2.3

2.5

13.4%

Maquiladoras

2.9%

1990 91 92 93 94 95 96 97 98 99 2000
12 12 12 12

have grown even


faster than
domestic
companies in
both value added
and employment

However,
2.9%

-1.8%

productivity has
actually declined
since the crisis

Employment
Thousands

1990 91 92 93 94 95 96 97 98 99 2000
211
189
173
159
136
119
7.5%

126
101103

102
73

13.4%

2.9%

1990 91 92 93 94 95 96 97 98 99 2000
Source: INEGI; team analysis

Maquila
advantage is
being phased out
under NAFTA

57

International companies brought new capital and better practices to the


local market. But productivity in components grew much less than in
assembly; it rose mildly among domestic suppliers, and declined slightly
in the labor-intensive maquiladoras5 (exhibits 13 and 14).
Distribution of FDI impact. Most companies (some luxury brands excluded)
have seen margins decline as the competitive intensity has increased.
Employment and wages have risen; quality and prices for consumers have
improved; and the government has avoided giving large incentives.
Companies. Data on profitability is not available, but the evidence suggests
that despite strong growth, OEMs have been facing slimmer margins in
recent years. This is due to the intense level of competition, which is forcing
OEMs to make ongoing improvements in quality and productivity while
offering increasingly attractive prices and financing packages.
Employees. Employment levels in Mexico have increased since NAFTA, and
wage growth has been rapid.
Level. Employment declined in the mature FDI period, as productivity
growth outpaced production growth. It began rising in 1994, at the start
of the Incremental FDI period, thanks to NAFTA and strong growth in the
U.S. market.
Wages. Wages appear to have risen even faster than average productivity
and have certainly risen faster than in the U.S. and other developed
countries. Real wages in vehicle assembly rose by 16 percent a year; this
may reflect the success of labor's bargaining power, in addition to
improvements in productivity (Exhibit 15).
Consumers. Consumers have fared best, though this is due more to market
opening than to FDI.
Price decline. Real prices declined sharply, even when compared to
declining vehicle prices globally (Exhibit 16). In recent years, OEMs have
offered more attractive financing packages.
Product selection and quality. Model variety and quality has increased
(Exhibit 17). By the end of the decade, defect rates were on par with, or
even lower than, those of U.S.-made automobiles. In some cases,
American customers have specifically requested vehicles made in Mexico
rather than the same model made in the U.S.
Government. Sector expansion in the 1990s has most likely had a positive
effect on the government's budget through increased income taxes.
Revenues grew so rapidly that they more than offset for declining margins.
In addition, by not giving incentives, the federal and state governments have
avoided problems similar to those seen in Brazil.

5.

Maquiladoras were first established by the Mexican government in 1965 as part of the Border
Industrialization program, in order to increase the employment opportunities for Mexican
workers and to boost the economy. Maquiladoras are foreign-owned assembly plants that were
allowed, on a temporary basis, to import free of duty machinery and materials for production or
assembly by Mexican labor, and to re-export the products, primarily back to the U.S. This
allowed foreign-owned companies to decrease their cost base by taking advantage of lower
labor costs. Most plants are located on the Mexico-U.S. border.

58

Exhibit 15

MEXICO AUTO SECTOR WAGES, 1990-2000

Vehicle assembly
Automotive parts
Overall average

2001 Pesos

180000

16.3%

160000
140000
120000

13.9%

100000

13.2%

80000

Real wages rose most


rapidly in vehicle
assembly, reflecting
faster productivity growth

In both sub-sectors, real

60000

wages rose more rapidly


than productivity

40000
20000
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Note: Overall industry includes rubber products


Source: INEGI; team analysis

Exhibit 16

GENERAL AND VEHICLE PRICE LEVELS, 1995-2001

Consumer price index


Retail vehicle price

1995 = 100

6-year
CAGR
Percent
21.8

330

13.3

280
230
180
130
80
1995

Source: INEGI; INPC

1996

1997

1998

1999

2000

2001

Vehicle prices
have trailed
the consumer
price index

59

Exhibit 17

SPECIALIZATION IN PRODUCTION; DIVERSITY IN SALES


Number of models
Production

39

33

31

33

35

33

31

1995

1996

1997

1998

1999

2000

2001

Liberalization of
imports has allowed
OEMs to specialize
while offering more
variety to domestic
consumers

Sales

Units per model

82

96

103

128

78

114

146

1995

1996

1997

1998

1999

2000

2001

produced have risen


from 24,000 to
58,000 and OEMs
are benefiting from
increased economies
of scale

Source: Marketing Systems

Exhibit 18

CAPACITY AND UTILIZATION OF OEMS IN MEXICO 1995-2001


Thousand units
CAGR
1994-2001
Percent

1,600
Capacity

1,300

Spare
capacity

368

389

1,211

1,800

1,800

372

307

1,338

1,428

1,493

1,600

2,000

183

-10.9

1,889

1,817

12.0

262

1995

1996

1997

1998

1999

2000

2001

72

76

84

80

83

94

91

Note: Capacity figures are estimates


Source: AMIA; CSM worldwide

Veteran
OEMs have
expanded
capacity at
existing
plants, rather
than build new
plants
Since 1995,
production
has outpaced
capacity,
resulting in
high utilization
rates

Production 932

Utilization
Percent

7.4

2,000
111

60

Exhibit 19

CAPACITY AND UTILIZATION OF OEMs IN


MEXICO 1995-2001

Total capacity
Spare capacity
Production

Thousand units

Utilization

DCX

Ford

GM

1995
%

1998
%

2001
%

515

408

386

330

301

330

306
271*

220

208

94

98

415

415

VW

215

187

65

57

Most
automakers
increased their
capacity at
existing plants

447

400

362

69

310

230

198

75

90

R/N

115

87

In general,
production rose
faster than
capacity

Honda

330

20*

340

265
339

185

381

108

82

92

58

56

24

190

187

71

10
328

96

72

119

* For GM in 1998 and Honda in 2001, production exceeded normal full utilization levels
Source: CSM Worldwide

Exhibit 20

PHYSICAL LABOR PRODUCTIVITY IN NORTH AMERICA, 2001


Cars per person per hour

GM

DCX

Ford

Labor
0.053

0.050
0.043
0.038

0.036

0.038

0.029

0.029

0.026

productivity in
Mexico is 70%
of U.S. levels,
in part because
management
chooses to use
more laborintensive
production

Labor
productivity in
Mexico has
risen sharply in
recent years
Canada

U.S.

Source: Harbour

Mexico

Canada

U.S.

Mexico

Canada

U.S.

Mexico

61

HOW FDI HAS ACHIEVED IMPACT


The new economic policies exposed OEMs to more competition. They responded
by specializing their production across North America while increasing consumer
selection through imports, thereby achieving economies of scale. Adoption of
lean techniques and more efficient organization of suppliers have also contributed
to higher productivity.
Operational Factors. The operational impact of additional FDI was mainly to
expand capacity, increase the level of automation, and (to a lesser extent)
improve quality, thereby making exports more attractive.
Capacity expansion. The new wave of FDI brought the capital required for
additional capacity. Capacity increased from about 1.3 million units in 1994
to 2.0 million in 2001, but since production volume was growing even more
rapidly, capacity utilization rose as well (Exhibit 18). GM, VW, and DCX led
the way in capacity expansion (Exhibit 19). FDI also enabled higher levels
of automation and other production improvements.
Specialization. While the number of models available to consumers nearly
doubled from 1995 to 2001, the number of models being produced actually
declined from 39 to 31 (Exhibit 17). Reducing the number of models while
capacity was expanded enabled OEMs to capture economies of scale; plant
activities were simplified, and OEMs had to invest less capital per vehicle.
Management practices. OEMs in Mexico drew on the skills and expertise of
their parent organization in adopting the practices of high-performing plants.
Managers from advanced plants were transferred on a short-term basis to
help move the plants to lean production techniques and more efficient
relations with suppliers.
Industry dynamics. Competition has increased to some extent due to FDI;
most of the increase has been due to policy liberalization.
FDI brought more competition in the form of new entrants and capacity
build-up. OEMs lowered their prices in real terms (Exhibit 16) and offered
zero-percent financing. Those who sold imports listed in dollars offered
favorable exchange rates to customers in order to reach their sales targets.
Most of the increase in competitive intensity is due to NAFTA and, in
particular, to the increased availability of U.S. imports.
EXTERNAL FACTORS THAT AFFECTED THE IMPACT OF FDI
Country-specific factors. Liberalization reforms have made FDI more
effective. The financial crisis of 1995 did no lasting damage to the industry
(Exhibit 1).
Relative position. Mexico's proximity and well established ground and sea
transportation to the U.S. has facilitated its integration into the North
American market, both through competition with U.S. products and through
exposure to best practices. Low wages in Mexico have caused managers to
choose more labor-intensive production a rational decision to accept lower
labor productivity (Exhibit 20). (OEMs in Mexico have found that even rural
workers with no manufacturing experience can be trained quickly).

62

Government policies. Liberalization has enabled OEMs to rationalize


production across North America and other geographies. The result is that
OEMs can specialize by producing fewer models, thereby capturing
economies of scale. Meanwhile, the variety of options available to
consumers is steadily improving (Exhibit 17). The government normalized
regulations and worked to attract suppliers, marginally improving the impact
of FDI in assembly.
Macroeconomic factors. The most important macroeconomic factor has
been robust growth in the U.S. market in the late 1990s. But the Tequila
Crisis of 1995 led OEMs to export more, and may have actually sped up the
process of specialization, putting OEMs in a better position to take
advantage of the growing U.S. market.
Initial sector conditions. By the time NAFTA began to take effect, at the start
of the period under review, Mexico's auto sector was already becoming
competitive and the gap with best practices was beginning to narrow. However,
at that point the gap remained significant, leaving plenty of room for
liberalization, competition, and the new wave of incremental FDI to have
impact.
SUMMARY OF FDI IMPACT
Overall impact of FDI has been very positive after liberalization, as OEMs have
rationalized production across North America while broadening model offering to
domestic consumers. Rising productivity, coupled with high plant utilization,
resulted in a large increase in value added, which was shared among various
stakeholders in the form of investment returns, wages, and consumer surplus. The
Mexican government also benefited from higher tax revenues and without giving
away large incentives.

63

Exhibit 21

MEXICO AUTO SUMMARY

External
factors
2
1

Industry
dynamics

FDI

3
3
Operational
factors

Sector
performance

1 Automotive Decree liberalized imports and reduced LCRs in 1990; NAFTA


further reduced tariffs and LCRs in 1994. Liberalization forced OEMs to
compete with imports but enabled them to rationalize production across
North America.
2 Efficiency-seeking FDI began in the late 1980s, as OEMs built new plants
in anticipation of liberalization. Since NAFTA, OEMs have focused on
upgrades at existing facilities; overcapacity and strong US unions have for
the time being prevented OEMs from building new plants in Mexico.
3 Productivity improved rapidly in the 1990s, for three related reasons:
Increasing competitive intensity encouraged plant upgrades and
adoption of best practices.
NAFTA enabled rationalization of production across countries, allowing
for specialization and economies of scale.
Rising demand from the US led to greater capacity utilization.
4 Overall impact of FDI has been very positive after liberalization, as
OEMs have rationalized production across North America while
broadening model offering to domestic consumers. Rising
productivity coupled with high utilization resulted in a large increase in
value added, which was shared among various stakeholders in the form of
investment returns, wages, and consumer surplus. Government also
benefited from higher tax revenues without giving away large
sweeteners.

Exhibit 22

MEXICO AUTO FDI OVERVIEW


FDI periods
Focus period: Incremental FDI

1994-2000

Comparison period: Mature FDI

1990-1994

Total FDI inflow (1994-2000)*

$3.7 billion

Annual average

$0.6 billion

Annual average as a share of sector value added

6.5%

Annual average as share of GDP**

0.10%

Annual average per employee

~ $12k

Entry motive (percent of total)


Market seeking
Efficiency seeking

30%
70%

Entry mode (percent of total)


Acquisitions

0%

JVs

0%

Greenfield

100%

* Food retail including discount warehouses


** Using 2001 GDP
Source: SECOFI; Registro Nacional de Inversiones Extranjeras

64

Exhibit 23

MEXICO AUTO FDIs ECONOMIC IMPACT IN


HOST COUNTRY
Sector performance
during
Economic
impact

Mature FDI Incremental


(1990-94)
FDI (94-00)

Sector

7%

11%

FDI
impact
++

productivity
(CAGR)

++
+

Highly positive
Positive
Neutral
Negative
Highly negative
[ ] Estimate

Evidence

Productivity grew rapidly from the start of the decade, as a result of


the competitive intensity created by import and price liberalization

Further liberalization under NAFTA, coupled with strong growth in


the US market, led to even more rapid productivity growth

Sector output

4%

15%

++

(CAGR)

Production growth was powered by growing exports, thanks to NAFTA


and to a growing US market.

The domestic market also grew significantly. It plunged in 1995, but


managed to fully recover by 1998, and has continued to grow. But
exports are still more important for the industry than domestic sales

Sector

-3%

4%

employment
(CAGR)

Employment declined in the early years, as productivity growth


outpaced production growth. But it began rising in 1994, thanks to
NAFTA and to strong growth in the US market

Suppliers

1%

0%

Value added and employment have grown for both domestic


suppliers and maquilas. But productivity growth has been minimal:
For domestic suppliers, productivity fell slightly in the early 1990s,
then grew at 4% since NAFTA
For the maquilas, productivity actually declined since NAFTA (but
both the levels and the rate of change are relatively small)

++

Impact on
Competitive
intensity

++

Sector liberalization and entry of new players caused an increase in


competitive intensity, and OEMs faced pressure to make dramatic
improvements in productivity and quality. Nevertheless profit margins
remained high, thanks to high market growth and capacity utilization

Exhibit 24

MEXICO AUTO FDIs DISTRIBUTIONAL IMPACT IN


HOST COUNTRY

__
[ ]

Sector performance
during
Economic
impact

Mature FDI
(1990-94)

++
+

Incremental FDI
FDI (94-00) impact

Evidence

Companies
FDI companies

[+]

[+]

[+]

Reliable data on company profitability unavailable, but increases in


productivity and capacity utilization suggest that profitability also rose

Non-FDI
companies

N/A

N/A

N/A

-3%

4%

No domestic makers of light vehicles

Employees
Level of
employment
(CAGR)
Wages

Employment declined in the early years, as productivity growth


outpaced production growth. But it began rising in 1994, thanks to
NAFTA and to strong growth in the US market

12%

14%

++

Wages appear to have risen even faster than average productivity.


This may be due to the success of unions in profitable times

++

Real prices have declined especially in recent years, as

Consumers
Prices

OEMs have offered more attractive financing packages

Selection

++

Model variety and quality has increased, the specialization of


production notwithstanding

Government
Taxes/Sweeteners

Government has benefited from industry growth through higher tax


revenues and has avoided giving large sweeteners

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

65

Exhibit 25
High due to FDI
High not due to FDI

MEXICO AUTO COMPETITIVE INTENSITY


Sector
performance during

Low
Incremental
FDI (94-00)

Mature FDI
(1990-94)

Rationale for FDI


contribution

Evidence

Liberalization meant that OEMs FDI added to the pressure to

Pressure on
profitability

New entrants

would have to compete for profits;


still, profits were high in the late
90s thanks to strong demand
Newcomers entered as

importers; none has yet


built large capacity

There were no exits in the


Weak player exits

market entry, not (yet)


any important exits

Real prices declined due to

Price competition came from

liberalization, and improvements


in quality and productivity

Market shares shifted, but not

Changing market
shares

Pressure on product
quality/variety

Competitive pressure
from importers remains
more significant than
entry of new producers

New wave of FDI led to

1990s (last significant exit


was Renault in 1980s)

Pressure on prices

gain high returns, but did not


increase competition overall

price liberalization, but was


exacerbated by overcapacity

No evidence that market

drastically; newcomers took


little share from the Big 5

shares were more volatile


because of FDI

Steady increase in number of

Imports brought more variety

models; expansion of new


segments

directly, and prompted OEMs in


Brazil to increase their variety

Entry of newcomers for


production added to variety
Pressure from
upstream/downstream industries

Being few in number, OEMs


enjoyed market power relative
to both suppliers and dealers

On the whole, real prices


Overall

declined as quality and


productivity were improving

Additional FDI and entry of new


players was not enough to give
power to suppliers and dealers

Competition was driven by


import liberalization and
exposure to the US market

Exhibit 26

MEXICO AUTO EXTERNAL FACTORS


EFFECT ON FDI
Level of FDI*
Global industry
Global
discontinuity
factors

Impact on
level of FDI Comments
0.10%

++ Highly positive

Impact
on per
$ impact Comments

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

O
++
+
O

NAFTA included Mexico in N, Amer. ++


Wages those of US (but other
+
O

growth of US market led to rapid


growth in Mexican production volume

Macro factors
Country stability

Crisis of 1995 had only limited impact on

countries offer even lower wages)

Domestic market recovered after 95


Rationalization of production and

productivity, since OEMs shifted to exports


Product market regulations
Import barriers
Preferential export access
Country Recent opening to FDI
specific
Remaining FDI restrictions
factors
Government incentives
TRIMs
Corporate governance
Taxes and other

+
++
O
O
O
+

Capital market deficiencies

Labor market deficiencies

Informality

Supplier base/
infrastructure

Sector
initial
conditions

Competitive intensity

+ (H)

Some barriers remained until 2004


Ability to import and to access
NAFTA attracted more investment

LCRs and trade-balancing reqs*


Unions in the US restrained OEMs
ability to relocate to Mexico

Import and price liberalization led

O
++
O
O
O
+
+
O

+ (M)

Gap caused OEMs to invest even

to shift quickly to exports

TRIMs contributed to size not to


productivity of local parts industry

Headquarters aided in knowledge transfer

+ (H)

Competition led OEMs to focus on productivity

+ (M)

Gap meant that the new wave of FDI had

(though the results were marred by overcapacity)

OEMs to invest in upgrades


Gap to best practice

NAFTA made it possible for OEMs

opportunity for real impact


more in state-of-the-art new facilities
* Average annual inflow as a percentage of GDP
** LCRs gradually phased out, but replaced with 62.5% regional content requirement for NAFTA. Also, other RCRs with other countries

66

Exhibit 27

MEXICO AUTO FDI IMPACT SUMMARY

[ ] Extrapolation ++ Highly positive

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

External Factor impact on


FDI impact on host country
Level of FDI relative to sector*

6.5%

Economic impact

Sector productivity
Sector output

Level of FDI
Level of FDI** relative to GDP
Global factors

++
++

Sector employment
+

Suppliers

Impact on
competitive intensity

Distributional impact
Countryspecific factors

Companies
FDI companies

[+]

Non-FDI companies

N/A

Employees
Level
Wages

Selection

Government
Taxes

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

O
++
+
O

+
++
+
O

Macro factors
Country stability

Product market regulations


Import barriers
Preferential export access
Recent opening to FDI
Remaining FDI restriction
Government incentives
TRIMs
Corporate governance
Taxes and other

+
++
O
O
O
+

O
++
O
O
O
+
+
O

Capital markets

Labor markets

Informality

Supplier base/
infrastructure

Global industry
discontinuity

+
++

Consumers
Prices

Per $ impact
of FDI

0.10%

+
+
+

* Average annual FDI/sector value added


** Average (sector FDI inflow/total GDP) in key era analyzed

Competitive intensity

+ (H)

+ (H)

Gap to best practice

+ (M)

+ (M)

Sector initial
conditions

China Auto Sector


Summary
EXECUTIVE SUMMARY
China has historically had strong FDI barriers. Earlier, only persistent companies
were able to negotiate entry in the initial stages. VW and Beijing Jeep were the
first to enter the market in the mid 1980s and Peugeot and Suzuki followed in the
early 1990s. Entrance by FDI accelerated in the late 1990s. Among the most
important recent entrants are GM, Honda and, more recently, Nissan and Ford.
Driven by its market potential, China's auto sector is now a magnet for FDI. Most
of the major global companies have now entered China, with an acceleration in
the rate of entry since 1998. All of the companies that have entered the Chinese
market have done so through joint ventures with Chinese state-owned enterprises
(SOEs), as is required by the government.
Overall FDI has had a positive impact on China's auto sector. FDI has contributed
by bringing products and processes to China that are far superior to those that
were present in the SOE incumbents. A reduction in entry barriers in the late
1990s and early 2000s, allowed more FDI companies into the Chinese market.
This helped increase the level of competition as evidenced by the rapid decline in
prices and an increase in number and quality of models available. FDI has also
helped create significant investment in China's components industry. Because of
heavy OEM investments in creating supplier bases, high levels of localization have
been achieved and China is today a large exporter of auto components.
The impact of FDI on China's auto industry has still not reached its maximum
potential. Government license controls ensure that China's auto industry remains
supply constrained and demand far outpaces supply. As a result, there is limited
competition and OEMs operate at relatively low productivity levels. Prices remain
70 percent above the world average, and profitability remains above the expected
risk-adjusted rate of return. As capacity continues to expand in the Chinese
market with the decrease of entry barriers, we expect supply will outgrow demand,
competition will increase, and prices and profitability will continue to decline.
However, ongoing finished good import tariffs of 25 percent will continue to reduce
the overall impact of FDI marginally, even when domestic supply outpaces
demand.
SECTOR OVERVIEW
Sector overview. The Chinese passenger car sector produced approximately
1.1 million automobiles in 2002, displaying an annual growth rate of 25
percent from 2000 (Exhibit 1). This represents around $12 billion in sales and
nearly $3 billion in value add in the auto industry.
Though China's sector is rapidly closing the market penetration gap it still
appears to be somewhat under-penetrated by global standards (Exhibit 2).
Consumers are replacing governments and institutional purchasers rapidly
as the biggest market segment; this has made economy automobiles an
increasingly important segment (Exhibit 3).

67

68

Exhibit 1

TOTAL CHINA AUTO SECTOR LOCAL PRODUCTION SALES


BY SEGMENT 1995-2002
Million units; percent

CAGR
3.6%
1.60

CAGR
14.1%
1.83

1.44

1.46

1.56

Car

22

30

32

Bus

33

27
26

27

27

28

Truck*

44

47

43

41

1995

1996

1997

1998

CAGR
24.7%

3.25

2.36

35

2.09
29

31

31
32

34

35

41

37

35

1999

2000

2001

33
2002

* Includes all trucks including light and mini-duty


Source: China Automotive Industry Yearbook, 1998-2002; Literature search

Exhibit 2

CARS PER THOUSAND INHABITANTS VS. GDP PER CAPITA 2000


Cars per
400
thousand
residents
350
2000

Portugal

300

Greece

250
Hungary

200
Malaysia

150

Argentina

Korea

Russia
Brazil

100

Mexico
Turkey

50
0
0

Colombia
Indo- Peru
Thailand
India nesia
Philippine
China
2,000
4,000
6,000
8,000

Chile

10,000

12,000

14,000

GDP per capita at PPP 2000

Source: DRI; World Bank; China Automotive Industry Year Book, 2001; China Statistical Year Book, 2001;
McKinsey analysis

16,000

18,000

69

Exports of components have grown rapidly to $1.8 billion, though China still
has a negative trade balance due to $3 billion in components imports.
Finished goods exports and imports are small (Exhibit 4).
FDI Overview. China's vehicle sector attracted approximately $4 billion of FDI
from 1998 to 2001. While significant, this represents only around two percent
of China' s total FDI over this time period. Many of the major companies have
now entered with an acceleration in the rate of entry occurring post-1998.
We have chosen to define the period before 1998 as "early FDI" and the period
from 1998 to 2001 as "maturing FDI", and have made a comparison of these
two periods (exhibits 5-8). To further understand the impact of FDI, we have
compared the passenger auto sector (FDI-dominated) with the truck and bus
sector (almost no FDI) where appropriate.
Early FDI. VW and Beijing Jeep entered the market in the mid-1980s with
Peugeot and Suzuki entering in the early 1990s. VW dominated the market
throughout this time period, holding over 60 percent market share in 1995.
Maturing FDI. Entrance by FDI accelerated in the late 1990s. Among the
most important recent entrants are GM, Honda and, more recently, Nissan
and Ford. All of these companies entered the Chinese market through joint
ventures with Chinese SOEs, as is required by the government.
External Factors driving the level of FDI. China's market potential has been
the strongest attractor of FDI especially as some of this potential began to
be realized in the late 1990s and early 2000s. Several government policies
have had positive or negative influences on FDI, with the entry barriers to FDI
being a key inhibitor.
Country specific factors. China's market even though income per capita is
still relatively low is perceived by FDI entrants to have significant growth
potential. Furthermore, import barriers and TRIMs have increased the
amount of FDI by making vehicle import impossible, and requiring OEMs to
invest in the creation of a local supply base. FDI barriers (each company
negotiates a specific entry agreement with the government) markedly
slowed FDI entry, especially prior to the entry of GM and Honda.
Sector market potential. China's market offers significant growth
potential, especially since prior to FDI, high prices reduced penetration.
Import barriers. Though the Japanese auto companies in particular had
hoped to gain sales in China through imports, the Chinese government
maintained a combination of high import tariffs, quotas, and local content
requirements to protect the local market. Once FDI companies had
entered the market with competitive models, this meant that a company
had to manufacture in China to have any chance at capturing local
market share.
FDI barriers. Entry to China is by no means easy even today. Both Honda
and GM spent more than four years negotiating with the Chinese
government to set up joint ventures in China. Ford, which was initially
excluded, was later able to partner with Changchun Auto. These FDI
barriers reduced the amount of total FDI in this study's focus period.

70

Exhibit 3

SALES OF PASSENGER CARS BY SEGMENT, 1995-2001*


Thousand units, percent
455

475

463

508

CAGR

570

611

721

40

38

35

-2%

25

25

11%

25

34

35

37

40

1998

1999

2000

2001

100%

32

Institution/
big company

57

60

64

34

Taxi

Private

22

22

21

15

18

21

1995

1996

1997

27%

* Including imports
Source: Literature search, McKinsey analysis

Exhibit 4

TRADE IN AUTO AND AUTO PARTS

Parts
Finished goods

$ Millions; percent

Breakdown of exports 2001


100% = $2,712 million

Exports

Special cars

Passenger cars
2,712
108%
increase

2,479

Trucks

2
23

35
38

Motorcycles
28

1,187
817
Final
goods
Parts

35

988
36

883
25

20

65

60

62

65

64

75

80

1996

1997

1998

1999

Parts (body and


accessories)

Engine and
chassis

2000

2001
Breakdown of imports 2001
100% = $4,703 million

Imports
57%
increase

4,703

Trucks

Special cars

4,048
4 3

36
29

2,580

2,500
2,078

2,058

35

40

66

65

60

1996

1997

1998

Final
goods

34

Parts

Passenger
29
cars

30
71

64

2000

2001

56

70
8

1999

Source: China Automotive Industry Yearbook, 1996-2001

Engine and
chassis

Parts (body and


accessories)

71

Exhibit 5

ERA ANALYSIS OF CHINA AUTO INDUSTRY


Limited Foreign
Participation
1985 - 1997

Completely Closed
Pre-1985
External
factors

No imports or foreign

Limited JVs allowed, with Government allowed and

investments in auto
sector

government approval

High tariffs on finishedvehicle imports together


with licenses and quotas
Low entry barriers for
local producers due to
government protection

Industry
dynamics

Growing Foreign
Participation
1998 - 2001

Three major SOE auto


makers
Planned economy with
no market competition

Performance Extremely backward


production techniques
with few models, using
Soviet techniques
/design
Production aimed
entirely at government
purchase

Post WTO
2001 and later

WTO will reduce tariffs

encouraged more JVs

to 25% and eliminate


quotas by 2006
interventions via screening, Regulations on foreign
foreign equity limits, local
investment in downcontent requirements
stream industries
Distribution still controlled
(distribution & financing)
by the government
would be removed

Highly government

VW became the first and Increasing car models and More competition in the
the only dominant foreign
declining prices
JV partner that virtually
Four major car maker JVs
locked on market for 10
dominated the market
years
Vertically integrated
players emerged

High price and high

Improved productivity
Most car OEMs remained
profitability for auto
to be more profitable than
makers
Profitability achieved with their global peers
high cost structures due
to the sub-optimal scale
of the supplier industry

passenger car market,


raise requirement on high
quality and low price
Increasing export in parts

Pressure on price may


lead to profitability
decline, but economy of
scale and improved cost
in supplier industry would
help to slow down the
drop
Continuous capacity
building may bring the
risk of overcapacity for
major car OEMs

Source: McKinsey analysis

Exhibit 6

OEM ENTRY IN CHINA


Shanghai Auto/(SAIC)
GM

Beijing Automotive (BAIC)/


Chrysler (Jeep)

1980s

Shanghai Automotive (SAIC)/


Volkswagen

First Auto Works


(FAW)/
Volkswagen

Jinbei/
GM*

Guangzhou Auto Group/


Honda
Dongfeng/Nissan

1990s

Dongfeng/ Changan/
Peugeot Suzuki

2000s

Changan/ Tianjin Xiali/


Toyota**
Ford

* Set up in 1992; restructured and expanded in 1998


** JV created in 2000, however production did not begin until October 2002; Tianjin Xiali was a standalone
company before the JV
Source: Company homepages; literature search; China Auto Industry Yearbook

72

Exhibit 7

CHINESE PASSENGER CAR OEMS MARKET SHARE, 2001


Percent

Market share of JVs

Fengshen Auto
Changan
/Suzuki
Guangzhou
/Honda

FAW Beijing Jeep

2.8 0.6
6.5

2.6

7.7

34.8

SAIC/VW

JV

Foreign
Partner

Local
Partner

SAIC/WW
FAW/VW
Toyota

VW
VW
Toyota

SAIC
FAW
TAIC

Citroen

Dongfeng

Suzuki

Changan

GM
Honda

SAIC
Guangzhou

Beijing Jeep

Daimler-

BAIC

Fengshen

Yunbao

/Tianjin Xiali
Toyota
7.7
/Tianjin Xiali

Dongfeng
/Citroen

Dongfeng
/Citroen

Changan

8.1

/Suzuki

SAIC/GM
Guangzhou

8.8
20.2

SAIC/GM

/Honda

FAW/VW

Auto
Chrysler

100% = 721,000 units


Total market share of JVs = 97 %

Auto

Auto (from

Dongfeng
Jingan Auto

Taiwan)

Source: China Automotive Industry Yearbook

Exhibit 8

PASSENGER CARS MARKET SHARES 1995-2001


Percent; thousand vehicles
100% =

455

SAIC/Volkswagen

463

51.2

FAW/Volkswagen

52.5

11.3

9.2

475

48.8

10.7

508

570

42.0

45.3

611

721

36.6

34.8

18.2

20.2

Beijing Jeep
Changan/Suzuki
Guangzhou/Peugot
Dongfeng/Citreon
FAW
SAIC/GM
Guangzhou/Honda
Fengshen Auto

20.5
20.9

12.7

1.6
0.5
0
0
0

7.7

8.0

1995

Source: Auto and Parts Magazine

19.3

6.8

0
0
0

3.5

1996

0.8 6.5
0.3 8.9

4.1

4.2

18.5

23.1

2.2

6.1
0.6 0.3
5.6
2.4
1.8 3.8

1997

1.6
6.8
0.5

0 10.9
0
0 2.9
1998

entered into
passenger cars
market, with two
late comers
(SAIC/GM and
Guangzhou/Hon
da) gained more
than 16% of the
market share in
3 years

14.9

13.5

Toyota/Tianjin Xiali

More players

8.1
7.3

0
0
0

2.9
4.2

1999

8.1
2.6

8.9

2.2
5.0
1.8
0 5.3

2000

8.8
7.7
0.6

2.8

2001

0.6
0

Some market
leaders lost
significant
market shares
due to more
intensive
competition

73

Initial sector conditions. Low competitive intensity has created high


profitability for OEMs (Exhibit 9), thus making China an attractive market.
Furthermore, the gap with best practice operations as evidenced by
outdated models such as the Santana and a significant productivity gap
strongly encouraged the entrance of new FDI companies.
FDI IMPACT ON HOST COUNTRY
Economic impact. Labor productivity and total factor productivity (TFP) grew
in both the maturing FDI period and the early FDI period, though TFP growth
accelerated in the later period. Sector output also accelerated rapidly,
especially after 2000, while employment grew marginally.
Sector productivity. To isolate the impact of FDI, we compared passenger
auto productivity growth with that of trucks and buses during the same time
period. While FDI controls 98 percent market share in passenger auto, it is
virtually non-existent in truck and bus manufacture.6 We conclude that FDI
had a marked impact on productivity levels, though truck and bus
productivity is now growing rapidly as well, driven by state sector
restructuring (exhibits 10-14).
Growth. Both trucks and buses and automobiles grew rapidly during
period under review but for very different reasons. Productivity growth
in automobiles was driven by large increases in value added while inputs
were increasing. With the rapid income growth in China, international
companies were well prepared to offer higher quality models to meet the
demand. Productivity increased as new companies entered with highproductivity plants and existing OEMs improved performance as a result
of increasing competition. In trucks and buses, the improvements were
driven by both growth in value added but also by significant cuts in
employment resulting from SOE restructuring.
Passenger auto. Labor productivity growth in passenger auto was stable
at approximately 30 percent per annum from 1995-2001; capital
productivity, meanwhile, dipped by 25 percent per annum from 19951998, then accelerated to over 20 percent a year from 1998- 2001.
The drop in capital productivity can be explained by a sharp investment in
new fixed assets between 1995 and 1997 (investment made ahead of
demand), which then slowed in the 1997-2001 time period.
Trucks and buses. Labor productivity grew at 10 percent CAGR from
1995-1998, then accelerated to 41 percent CAGR in 1998-2001.
Capital productivity showed a drop similar to that seen in passenger
automobiles in 1995-1998 (though somewhat less severe) and
accelerated to 21 percent CAGR in 1998-2001.
6.

Since the automobile and truck and bus industries manufacture similar products, they provide
a good mechanism for understanding the impact of FDI. Note that we have not carried out a
full examination of the truck and bus industries and cannot, therefore, explain these sectors'
performance in the same detail as we can in passenger automobiles. However, greater FDI for
passenger automobiles might be explained by the differences in import tariffs between
automobiles and trucks/buses; these are from 80-100 percent for automobiles and 50 percent
for trucks and buses. However, because of the WTO agreement, the significant differences
between these segments will be eliminated over time. By 2006, tariffs will be 25 percent for
both automobiles and buses and between 15 to 25 percent for trucks.

74

Exhibit 9

PASSENGER CAR JOINT VENTURE PROFITABILITY


Percent
1999
ROS

1998
ROS

2000
ROS

Guangzhou/
Honda

17.1

8.5

-21.4

SAIC/GM

19.0

17.6

17.8

SAIC/VW

23.9

17.5

20.9

FAW/VW

2001
ROS

N/A

22.7

27.7

Weighted
Average

20.6

18.4

18.4

22.1

23.1

18.2

21.1

21.7

Source: China Automotive online database; McKinsey analysis

Exhibit 10

CAPITAL PRODUCTIVITY CHINA AUTO SECTOR, 1995-2001


CAGR

Car OEMs
1.00

0.90

28.1%

-24.6%
22.1%
0.40

1995

Total Auto Sector

0.43

1997

0.82

0.64

0.46

1999

2001

Capital productivity
Truck and Bus OEMs (and other auto OEMs)
27.2%
0.49

-11.3%
0.41
0.33

1995

1997

37.4%

0.60

16.6%
0.41

0.47

0.46

0.34

1999

2001

-11.7%
0.38

1995

0.30

14.0%
0.37

0.56

0.41

0.32

1997

1999

2001

Engine and Parts manufacturers

0.43

0.34

1995

14.7%
0.44

-6.9%
0.36

10.4%
0.45

0.50

0.34

1997

* Using TFP = (Y/K)0.3(Y/L) 0.7


Source:China Automotive Industry Yearbook 1996-2002; McKinsey analysis

1999

2001

declined in the auto


sector from 1995 to
1998 due to heavy
investment in new
plants and
equipments, and
rebound from 1998
onward, as volume
picked up

75

Exhibit 11

LABOR PRODUCTIVITY OF CAR OEMs, 1995-2001


CAGR

Value added
2001 Real RMB Billions
49.1%
18.8

45.7%
20.2%
5.1

6.7

28.1

12.6
8.9

6.4

Labor productivity
Real 2001 RMB per Labor hour

For car OEMs,


25.4%

1995

1997

1999

2001

329.3

29.9% 262.7

30.6%
155.6
114.1

179.5

96.9
69.9

Labor input
Million Hours
-8.0%

1995

1997

1999

2001

73.2

12.1%
70.2

68.6
56.3

1995

18.9% 85.3
71.7

growth of labor
productivity is
mainly due to the
growth of value
added, especially
since 1998, as
number of
employees actually
increased gradually
in the car OEM
sector

57.1

1997

1999

2001

Source:China Auto Industry Yearbook 1996-2002; McKinsey analysis

Exhibit 12

CAPITAL PRODUCTIVITY OF CAR OEMs, 1995-2001


CAGR

Value added
2001 Real RMB Billions
49.1%
45.7%
20.2%
5.1

6.7

28.1

18.8

12.6
8.9

6.4

Capital productivity
Real 2001 RMB per RMB net fixed assets
1995
1.00

1999

2001

28.1%

0.90 -24.6%

0.82

22.1%
0.40

1997

0.43

0.64

0.46

Net Fixed Assets


Nominal RMB Billions
1995

1997

1999

16.4%
34.2

2001

19.3%
29.4
27.2
20.6

59.4% 16.0
5.1

1995

7.4

1997

Source:China Auto Industry Yearbook 1996-2002; McKinsey analysis

1999

2001

Capital productivity
of car OEMs
declined significantly
due to the heavy
investment from
1995 to 1998 and
rebound from 1998
onward, as volume
picked up and
increase in value
added outpaced
increase in net fixed
assets

76

Exhibit 13

LABOR PRODUCTIVITY OF TRUCK AND BUS


MANUFACTURERS, 1995-2001

CAGR

Value added
2001 Real RMB Billions

40.1

34.2%

10.6%
16.5 17.1

13.9

26.0%
23.9

29.9

18.8

Labor productivity
Real 2001 RMB per Labor hour

For truck and bus


1995

1997

1999

2001

66.0% 30.9
30.3%
10.0%
8.2

9.9

9.9

16.1

18.6

11.0

Labor input
Billion Hours
1995

1997

1999

2001

0.5%
1.69

1.68

1995

-3.3%

1.72

1.72
1.49

1997

OEMs, growth of
labor productivity is
mainly due to the
growth of value
added, but in 2001,
significant decline
in employment also
played an
important role in
increase of labor
productivity

-19.1%
1.6
1.3

1999

2001

Source:China Auto Industry Yearbook 1996-2002; McKinsey analysis

Exhibit 14

COMPARISON BETWEEN CHINA (2001) AND US LABOR


PRODUCTIVITY
Car OEMs
100

52
38
21

US

China 4
JVs

China BP

Total Auto Sector

China 13
large

Truck and Bus OEMs (and other auto OEMs)

100

100

14

7
US

China

US

China
large

10

China
sector

Engine and Parts manufacturers


100

16
3

US

China 4
JVs

Source:China Automotive Industry Yearbook 1996-2002; McKinsey analysis

China
sector

JVs have
consistently higher
productivity
Overall sector
productivity is low
due to large
number of small
(SOE) producers

77

Levels. Labor productivity levels in passenger autos are significantly


higher than those seen in trucks and buses. Given that the industries are
somewhat similar and have similar inputs to create the finished product,
it appears that FDI may have played a role in the earlier development of
higher productivity in the passenger car segment.
Passenger car. The average productivity levels across thirteen joint
ventures are at 21 percent of U.S. levels; a sample of four large joint
ventures shows that they achieve 38 percent U.S. levels, and a best
practice company achieves 52 percent U.S. levels.
Trucks and buses. The sector as a whole achieves only 10 percent of
U.S. levels and a sample of large companies shows a level of 14 percent.
Sector output. Growth in value-added accelerated sharply in the maturing
FDI period, to over 45 percent per annum. This contrasts with only
20 percent in the 1995-1998 period. One cannot trace this acceleration
to increased GDP growth, as real GDP growth was similar in both periods, at
about seven percent CAGR. There are several possible explanations for the
difference in growth rates. It might be due in part to the increasing number
of Chinese households crossing the 'automobile affordability threshold'
income of $14,500 per household. Financing has also become available
increasingly in the period under review, helping spur the acceleration.
Finally, increasing competition as evidenced by lower prices helped
induce growth. This is where FDI played a stronger role by creating more
competition (see "How FDI has achieved impact" for further details).
Employment. Employment grew at roughly 14 percent per annum in the
maturing FDI period, while having declined by 8 percent per year in the
earlier period. Output and employment growth seem to be tightly linked;
employment growth, therefore, can only be attributed to FDI in the same
proportion that output growth is (see above for more details).
Supplier spillovers. Most FDI entrants made significant investment in
building supply bases. For example, GM and Ford both invested in
anticipation of their entry in 1998 though only GM was granted permission
to enter at that time and Ford's suppliers remained to serve other OEMs (and
eventually Ford when it entered). Because of heavy OEM investments in
creating supplier bases, high levels of localization have been achieved
(exhibits 15 and 16).
Distribution of FDI impact. FDI-companies, non-FDI companies, consumers,
employees, and the government have all benefited from increasing FDI in
China. Many FDI companies have benefited from risk- adjusted profits, though
some FDI-companies who have lost out. Consumers have benefited from the
continuous decrease in prices and increases in quality and number of models
available, though additional benefits will be captured as competition continues
to intensify.
Companies
FDI companies. FDI firms have generally performed very well in China
with a pre-tax return of sales in excess of 20 percent as compared to five
percent in the rest of the world (Exhibit 17). However, some firms (such
as Jeep and Peugeout) have been less successful, with large losses and
low market share (Exhibit 8). Key success factors in the market include

78

Exhibit 15

OEMS INVESTMENT IN BUILDING LOCAL SUPPLY BASE GM EXAMPLE

Joint Venture

Location

Formed In

Chinese Partner

Products

Saginaw Zhejiang Xiaoshan


Steering Gear

Xiaoshan
(Zhejiang)

1996

Zhejiang Wanda Steering


Gear Co.

Steering columns, intermediate


shafts, steering gears

Shanghai Saginaw Steering

Shanghai

1996

Dongfeng Motors

Pinions and driving gears

Asia-Pacific Braking Systems

Zhejiang

1996

Zhejiang Asia-Pacific
Mechanical/Electrical Group

Braking components and


assemblies

Hubei Delphi Automotive


Generator Group

Wuhan

1996

Hubei Super-Elec Auto Electric


Motor Ltd.

Generators

Shanghai Delco Battery

Shanghai

1995

Shanghai Mechanical/Electrical
Industrial Investment Co.

Enclosed maintenance-free
batteries

Packard Electric BaiCheng

Baicheng (Jilin)

1994

Baicheng Auto Wires

Ignition wires, wire harnesses

Packard Sanlian

Shanghai

1995

Shanghai Sanlian Wire Harness

Wire harnesses

Saginaw Norinco Ling Yun Drive


Shaft

Zhuozhou
(Hebei)

1995

Norinco China North Industries


Group

Axle shafts and constant velocity


joints

Wanyuan GM Electronic
Control Co.

Beijing

1994

Wanyuan Industrial Co.

Engine management systems

Packard Hebi

Hebi (Henan)

1995

Hebi Auto Electrical

Central distribution terminal,


connectors

Delphi Shanghai Steering and


Chassis Systems. Co

Shanghai

(Wholly owned by Delphi)

Steering and brake system

Including wholly-owned ventures, GM(Delphi) has invested


well over $200 million in China to date

Source: Asian News Service; Financial Times; Dow Jones News Service; Wards Auto World

Exhibit 16

LOCAL CONTENT INCREASE

NOT EXCLUSIVE

Percent
Global OEMs cooperate with 1-tier
suppliers, e.g., Visteon, Delphi and Bosch
to localize their production in China
1987
Tianjin
(Daihatsu)
Shanghai VW
Charade
(Daihatsu)

80%

1992

80%

1994

97

13
19

47
31

80%

98

75

FAW
Audi 100

2000

80%

93

86

93

84

94

62

83
90

Chongqing Auto

85

FAW-VW Jetta
30

Beijing Jeep
Guangzhou
Peugeot

12

All producers
started by
importing
components
Source: Literature search; China Infobank

80

57
40

Only one
manufacturer
achieved over
80% local
content

60

Most of the
major
producers
obtained 80%
local content

90

N.A.

All over 80%


local content

Localization in
order to
reduce the
need for
foreign
currency and
production
costs

79

Exhibit 17

PROFITABILITY IN CHINESE AUTOMOBILE SUB-SECTOR


VS. WORLD AVERAGE***
Pre-tax ROS, percent
25

4 JVs* in China
China JV
China SOE
China Total
World average**

20
15
10
5
0
-5
1998

1999

2000

2001

* 4 top JVs are FAW/VW, SAIC/VW, Guangzhou/Honda, SAIC/GM


** The world average is the non weighted average of ROS of GM, DCX, Ford, Toyota, VW, Honda, Renault &
Nissan, PSA and BMW; it includes non manufacturing activities of OEMs, and the 9 companies may use various
accounting standards
*** Non-risk adjusted ROICs would range between 20% (at GM capital structure) and 80% (at Honda capital
structure), indicating that this indeed represents excess returns
Source: China Automotive Yearbook; McKinsey analysis

80

the chosen partnership strategy, product and positioning, servicing


strategy, and the building of a strong supplier base.
Non-FDI companies. The immediate impact of FDI in the mid-1980s was
the complete domination of the passenger automobile market by
international joint venture companies and a corresponding reduction in
the market share of non-FDI companies.
Though the Chinese
government has enacted a policy aimed specifically at allowing Chinese
companies to eventually re-emerge in the market including the joint
venture requirement for all FDI and other trade barriers Chinese
companies show little sign of developing into strong, standalone ability in
auto manufacture. Furthermore, according to our interviews, they have
not made substantial headway in transferring best practices from joint
venture operations to non-joint venture operations. However, they have
benefited from the high profits generated by their joint ventures
themselves.
Employment
Employment levels. An employment increase in the latter period can be
attributed to output growth. This growth in output can in turn be attributed
to the increasing numbers of Chinese population who are able to afford
automobiles because of greater income, increased availability of
financing, and lower prices due to the growing level of competition due to
more FDI-players in the market.
Wages. Wages are higher in FDI-auto companies than in general
manufacturing jobs. Wages in one auto company range from RMB
3,000-4,000 monthly for a line worker, while an unskilled manufacturing
worker in China typically earns RMB 800-1,200 per month (Exhibit 18).
Consumers
Price declines. Prices increased by 10 percent in the overall economy
between 1995-2001 while they decreased by 31 percent in passenger
automobiles over the same period. We believe the continually increasing
number of FDI-companies in the market place helps explain this price
decline (Exhibit 19).
Product selection and quality. The number of models available to
Chinese consumers grew rapidly over the period under review. While the
outdated Santana dominated sales through the early-1990s, more up-todate models, such as the Accord and the Buick Regal, began to gain
market share in the late-1990s and early 2000s. Quality improved
continuously, reaching international levels. Again, the entry of FDI
companies helps explain this improvement in selection and quality
(exhibits 20-22).
Government. Tax revenues from the auto sector, tied to the growth in
output, increased steadily throughout this period. FDI contributed to
additional government revenues to the extent that it helped spur output
growth (Exhibit 23).

81

Exhibit 18

WAGE COMPARISON AUTO OEM JOINT VENTURE VS. CHINA AVERAGE


Unskilled labor, wage per month in RMB

3,000 4,000

800 1,500

OEM JV

Typical unskilled
factory worker

Source: Interviews

Exhibit 19

PRICE EVOLUTION FOR DIFFERENT MODELS


Thousand RMB (nominal values)

200
180
160
140
120
100

Santana 2000

Average price
decrease of 31%
from 1995 to 2002

Fukang 1.6
Jetta
Fukang 1.4

80
60
40

TJ7100 Charade

20
0
1995 1996 1997 1998 1999 2000 2001 2002

Note: List price does not necessarily reflect transaction price; incentives have to be investigated further; other possible
methodological issues include change in car quality
Source: Access Asia; Press Search

82

Exhibit 20

CHANGE OF VARIETY OF CAR MODELS AVAILABLE IN CHINA


1998-2001
Car models in China, 1995

Car models in China, 2001

Retail Price
(RMB 000)

Retail Price
(RMB 000)

400

400

VW Audi A6

350

350

Honda Accord
GM Buick

300

300

Honda Accord2.0
Brilliance Zhonghua
SAW Bluebird

VW Passat

250

Audi100.
Red Flag7221

200

Cherokee
7260

VW Santana
VW Jetta
Peugeot 505
Gtroen EX

150

250
Citroen Picasso

FAW Red Flag


Mazda Premacy

200

VW Polo
Changan Alto
Qinchuan Xiaofuxin

150

Yunque

100

Changan Alto

50

50

Citroen DC
Yuejin Encore
VW Santana GL
GM Sail
SAIC Cherry
Changan Lingyang
KIA Pride
Changhe
Geely
TAIC Xiali
Geely Haoqing

TAIC Xiali 2000


Nanya Palio

TAIC Xiali

100

VW Bora
VW Santana 2000
VW Jetta

Yunque

Engine (L)

Engine (L)

0
0.6

0.8
Mini

1.0

1.2

1.4

Standard
(economy)

1.6

1.8
Lowermedium

2.0

2.5

0.6

3.0

Upper- Highmedium end

0.8
Mini

1.0

1.2

1.4

1.6

Standard
(economy)

1.8
Lowermedium

2.0

2.5

3.0

Upper- Highmedium end

Source: McKinsey analysis

Exhibit 21

NUMBER OF LOCALLY PRODUCED NEW CAR MODELS BY SUBSEGMENT


Number of models

Luxury
V>4.0L

1995

2000

High-class
0
2.5<V< =4.0L
Standard
1.6<V<=2.5L

Economy
1<V<=1.6L
Mini
V<=1.0 L

2001

10

Source: China Automotive Industry Yearbook; China Auto 2000

14

20

10

83

Exhibit 22

MOREOVER, CHINA HAS PROVEN ABILITY TO MANUFACTURE HIGH


QUALITY PRODUCTS
Guangzhou Honda is ranked the best quality plant
of Honda
Media
GZ Honda-produced Accord is regarded as the
best quality among all Honda overseas
manufacturing plants rated by Japanese experts
GZ Honda

The China plant is one of the Top 3 plants for Audi


worldwide
Analyst reports
Shanghai VW is consistently ranked among Top 5
plant by quality of VW world facilities
Analyst reports
The Passat made in China is even better than the
ones in Germany
German engineers

Source: Interviews; analyst reports; literature search

Exhibit 23

TAX CONTRIBUTION BY THE AUTO PRODUCTION SECTOR


IN CHINA, 1995-2001

CAGR

Billion RMB, percent

33.8
21.5%

29.4

Sales tax
24.0
4.9%
14.1

Income tax

19.0
15.5

13.6

VA tax

1995

1996

1997

Source: Literature search; McKinsey analysis

1998

1999

2000

2001

84

Exhibit 24

IMPACT OF WTO OVER CHINESE AUTO SECTOR


Area

Pre-WTO entry

Upon WTO entry

A few years after


WTO entry

Tariff

<3.0L*:
3.0L*:

51.9%
61.7%

25% in 2006
25% in 2006

Expanded to U.S.$ 6.9

Eliminated in 2005

Quota restriction
Local content
requirements

Manufacturing

Distribution

70%
80%
Global quota limits of U.S.$ 6
billion

40% of all parts must be


sourced locally

lifted (still subject to import


quotas)

Local content
requirement lifted (not
subject to import quotas)

No restriction on foreign

Same

for engine manufacturers


Max. 50% foreign ownership
for OEM

ownership
Restriction remains

Same

No foreign investment allowed

Foreign JV allowed, but no

Restriction on foreign

Foreign non-bank financial


institutions not allowed to
provide auto finance services

Private ownership

Local content requirement

Max. 50% foreign ownership

in auto distribution

Financing

billion**

Auto company ownership by


private Chinese owners
not allowed

controlling interest or foreign


partner

Allow foreign non-bank

owned distribution lifted


in 2006

Same

financial institutions to
provide auto finance

Private ownership
restrictions relaxed

* Based on engine displacement


** Increases by 15% annually
Source: China Automotive Yearbook; literature search; McKinsey analysis

Same

85

HOW FDI HAS ACHIEVED IMPACT


FDI achieved impact initially through operational factors (bringing more modern
production techniques and models to China) and over time through increased
competition, though room for even higher competitive intensity still exists.
Operational factors. FDI brought with it modern production techniques.
Plants in China were fitted with automated presses, paint and assembly lines,
and in some instances, welding systems. Companies captured increased
economies of scale by consolidating R&D capabilities into one central location
rater than having local offices, leading to a decrease in overhead costs (e.g.,
labor and infrastructure savings). Superior models also allowed joint venture
companies to build larger market shares and achieve economies of scale in
production.
Industry dynamics. FDI has improved the level of competition in the sector,
though the level of competition is still not high by international levels
(Exhibit 24). The impact of increased competition is evidenced in lower prices,
higher quality and more variety (exhibits 19-22). Interviews suggest that entry
barriers inhibited entry in the 1980s and 1990s; GM and Honda respectively
took more than four years to negotiate entry with the Chinese government.
EXTERNAL FACTORS THAT AFFECTED THE IMPACT OF FDI
Import barriers, the remaining barriers to FDI and TRIMs, have been the key
inhibitors to FDI impact in the maturing FDI period. A large gap with best practice
allowed FDI to achieve greater impact than otherwise (exhibits 24-29).
Country specific factors
Import barriers. Import barriers are a key inhibitor to even higher FDI impact.
Since the key FDI-companies in China are all operating at nearly 100
percent capacity utilization, the fact that there is no competition from
imports allows prices to remain at nearly 70 percent above U.S. levels.
These import barriers will continue to exist in the future, with import tariffs
leveling of at 25 percent post-WTO.
FDI entry barriers. Residual entry barriers also reduced competition in the
time period under examination, though these barriers were gradually
reduced in the late 1990s and early 2000s and should not be a factor in
the future.
Local content requirements. The regulations for local content requirement
also reduced the impact of FDI by forcing international companies to
manufacture locally at sub-optimal scale. This reduced productivity and
increases costs. These barriers have now been removed and should cease
to be a factor by 2006 (when the component import quota is removed).
Supplier base. A fragmented supplier base (partially caused by TRIMs)
increases the cost of building automobiles in China, and also decreases
OEM productivity by forcing the OEMs to perform some tasks they would like
to outsource to suppliers (e.g., cockpit assembly). Due to the reduction in
TRIMs/import barriers on components, in combination with market growth

86

Exhibit 25

EXTERNAL FACTORS INFLUENCE OVER CAR OEM


SECTOR PERFORMANCE

Completely closed
pre-1985

Limited foreign
1985-1997

External factor

Increaseing
foreign participation
1997-2001

Strength of impact
High
Low

Post WTO
2001-onward

Government
ownership
Trade barriers

External factors

Local content
requirements

negative impact
on sector performance has
been decreasing steadily
Trade barriers
may still be an
issue in future

Regional
protectionism
JV requirement

___

Entry restriction

Downstream
entry restrictions

___

Source: China Automotive Yearbook; literature search; McKinsey analysis

Exhibit 26

TARIFFS IN CHINESE AUTO SECTOR

240
220
200
180
160
140
120
100
80
60
40
20
0
1992

Source: China customs yearbook

1994

1996

Car (displacement >3.0 L)


Car (displacement <3.0 L)
Parts Bumper and Seat Belt
Parts Air Bag
Parts Gearbox for car

1998

2000

2002

87

Exhibit 27

COMPARISON OF PASSENGER CAR RETAIL PRICES IN CHINA AND


U.S. IN 2001
Dollars

VW Audi V6 1.8L

Honda Accord 2.0L

VW Passat B5 1.8T

34,200

Buick New Century


36,000

34,200

28,500

China

U.S.

China

23,000

21,750

21,750

19,000

China

U.S.

U.S.

China

U.S.

On average, passenger car retail


prices in China is 60% higher than that
in U.S., Europe and Japan

Source: Literature search; Interviews

Exhibit 28

WATERFALL COMPARING CAR PRICE IN CHINA TO U.S.

ROUGH ESTIMATE

Percent

170

10
160

20-25
10-20
0~5

20-30
5-10

Actual
price in
China

Additional List price


taxes and in China
fees

Source: Interviews; McKinsey analysis

Value
Added
Tax in
China

Difference Higher
Difference Lower
in profits Inventory in cost
TFP
of comcosts
ponents

-10-20

Lower
Labor
costs

100

Price in
U.S.

88

Exhibit 29

SUPPLY AND DEMAND IN CHINA AUTO SECTOR, 2001

ROUGH ESTIMATES

Price
20.0
$ Thousands
17.5
(1,100, 16.1)
15.0

Dead
weight
loss

Due to constrained

Excess profits*

World
price

12.5

(1,500, 11.0)
10.0

World profit level

Demand

7.5
Unmet
demand

5.0
2.5
0.0
0

200

400

600

Supply curve
* Includes excess profits off parts makers
Source: UBS Warburg; McKinsey analysis

800

1,000

1,200

Sales units

1,400

1,600

1,800

supply and tariff


protection unmet
demand is ~400,000
units (not including
income effects
in future)
Deadweight loss
is approximately
$900 million
Excess profits*
are $3 billion

89

and consolidation, this should be less of an inhibiting factor in the future.


Initial sector conditions. The substantial gap with best practice in the initial
period, allowed new FDI to have more impact than otherwise by enabling it
to achieve very high rates of productivity growth (30 percent per year) from
its initial low levels.
SUMMARY OF FDI IMPACT
Overall impact of FDI has been positive in China by bringing products and
processes that were far superior to those present in SOE incumbents. The
reduction in entry barriers in the late 1990s and early 2000s allowed more FDI
companies into the Chinese market and these helped increase competition, as
evidenced by rapid declines in price and the increase in number and quality of
auto models available.
The impact of FDI has still not reached its maximum potential; prices remain
70 percent above the world average, and profitability is still above the expected
risk-adjusted rate of return. As capacity continues to expand in the Chinese
market with the removal of entry barriers, we expect supply to outgrow demand,
competition to increase and prices and profitability to continue to decline in the
Chinese market. However, ongoing finished good import tariffs of 25 percent will
continue to reduce the overall impact of FDI marginally even when domestic
supply outpaces demand.

90

Exhibit 30

CHINA AUTO SUMMARY


1

A domestic market with extremely high potential size/growth


drives market seeking FDI to China. However, barriers to FDI
mean that foreign investors cannot come as quickly as they
would have otherwise

New entrants help to increase competitive intensity by bringing


updated models, driving lower prices

However, high trade barriers and barriers to FDI serve to reduce


competition. Since capacity utilization is very high (demand
outstripping supply) competitive intensity is improving but still not
as high as it could be. This manifests itself in very high profit
margins in both the supplier and assembly industries in China;
because of this prices are high and demand is suppressed

MNCs continue to bring best practice production techniques as


they have since the beginning which adds to productivity
growth

More importantly continually upgrading competition leads to a


growing market which leads to higher scale production and
increases efficiency through
scale economies

FDI impact has been positive in China by bringing products


and processes that were far superior to those present in
SOE incumbents. The Chinese auto industry is on the steep
slope of its S-curve of demand and productivity growth. Further
new entrants will continue to drive prices down which in turn will
fuel continued sales growth. China will likely become a more
important exporter when productivity reaches its potential

External
factors
1
3

FDI

Industry
dynamics

5
4
Operational
factors

Sector
performance

Exhibit 31

CHINA AUTO FDI OVERVIEW

Total FDI inflow (1998-2001)


Annual average
Annual average as a share of sector value added
Annual average per sector employee
Annual average as a share of GDP

$2.7 billion
$0.7 billion
33%
$16,600
0.06%

Entry motive (percent of total)


Market seeking
Efficiency seeking

100%
0%

Entry mode (percent of total)


Acquisitions

0%

JVs

100%

Greenfield

0%

Source: China Automotive Industry Yearbook, 1996-2001; Interviews; McKinsey analysis

91

Exhibit 32

CHINA AUTO FDI IMPACT IN HOST COUNTRY

++
+

[]

Economic impact

Early FDI*
(1980-1997)

Increasing
FDI (19972001)

FDI
impact

Sector productivity
(CAGR)

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

Evidence

Sector productivity grows extremely


rapidly as increased FDI enters sector
post-1998, though is still below total
potential

Sector output

(CAGR)

Sector output grows extremely rapidly


post-1998, though total auto
penetration is still lower than it could
be. Exports not that significant, though
imports have been steadily replaced

Sector employment

(CAGR)

Employment grows slowly as rapid


value add growth slightly outpaces very
high productivity growth

Suppliers

Significant supplier base building has


happened, very much driven by FDI.
Consolidation is starting to take place

Impact on
competitive
intensity (net
margin CAGR)

Competitive intensity is certainly


increasing post-1998, but is still not as
high as it could be

* Use 1995-97 as proxy for period


Source: McKinsey Global Institute

Exhibit 33

CHINA AUTO FDI IMPACT IN HOST COUNTRY

++
+

__
[]

Early FDI
(1980-1997)

Increasing
FDI
(1997-2001)

FDI
impact

MNEs

n/a

++

++

FDI players have extremely high

Domestic
companies

n/a

Local companies have gained

Distributional
impact

Evidence

Companies
ROIC, about 4 times world average
profits through JVs, but do not
appear to have acquired significant
standalone skills

Employees
Level of
employment
(CAGR)
Wages

n/a

See prior page for evidence

n/a

JV players workers earn more than


other manufacturing sectors

Consumers
Prices

n/a

Prices declining recently, but still far

Selection

n/a

Selection has increased markedly

above world averages


since 1998, both in number and
quality (newer) of models

Government
Taxes

n/a

Government collects almost 10% of


its taxes directly or indirectly through
auto sector; its growth has benefited
tax coffers

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

92

Exhibit 34
High due to FDI
High not due to FDI

CHINA AUTO COMPETITIVE INTENSITY

Low
Early FDI
(1980-1998)

Increasing
FDI (19982001)

Pressure on
profitability

Evidence

Rationale for
FDI contribution

Profitability very high

FDI controls market

by world standards

Many new entrants

All new entrants except

since 1998

New entrants

Brilliance China are FDI

Most players still in

FDI controls market

market

Weak player exits

Price has started to

Pressure on
prices

FDI controls market

decline, but still far


above world average

Market share starting

Changing market
shares

Driven mostly by GM

to shift with VW losing


some share

Several new models

Pressure on
product
quality/variety

and Honda

FDI responsible for all

being introduced across


each segment; older
Santana and Jetta
previously dominated

introductions except one

Pressure from
upstream/downstream industries

Competitive intensity is

FDI controls market

starting to increase but


not as high as it could be

Overall

Exhibit 35

CHINA AUTO EXTERNAL FACTORS EFFECT


ON FDI
Impact
Impact on
level of FDI Comments
Level of FDI*
Global industry
Global
discontinuity
factors
Relative position
Sector Market size potential

Highly negative

( ) Initial conditions

Extremely high potential especially

givers with low penetration

Prox. to large market


Labor costs

O
O

Language/culture/time zone

in) Macro factors


Country stability

Negative

+ Positive
O Neutral

on per
$ impact Comments

++

++ Highly positive

Not yet a major factor as entrants

O
O

have not entered to export


O

Stable currency and country

Stability allows for steady capacity

Reduce competition from imports, which would

O
O

Also continues to reduce competition

Higher cost components in some case due to

lack of scale/competitiveness in supplier


industries (TRIMs+ tariffs); especially harmful
in case of new production capacity where
supplier industries need time to develop

environment attracts investors


Product market regulations
Import barriers

Protected market requires FDI

Countryspecific Preferential export access


Recent opening to FDI
factors

O
+

More open auto FDI policy brings

Remaining FDI regulation

FDI regulation still slows entrance of

Government incentives
TRIMs

O
+

expansion without high risk

for access

be important due to high capacity utilization

several new entrants

Corporate Governance
Taxes and other
Capital deficiencies
Labor market deficiencies
Informality
Supplier base/infrastructure
Sector
initial
conditions

new players in studied period

TRIMs require faster investment in


building parts industry though
investment probably would have come
eventually

O
O
O
O
O
O

Competitive intensity

+(L)

Gap to best practice

++(H)

O
O
O
O
O

Increases attractiveness of local

Higher cost components in some case due to


lack of scale/competitiveness in supplier
industries

O (L)

market due to higher margins

Low level of productivity, outdated


models encourage new entry

+ (H)

Significant productivity growth (30+% CAGR)


achieved due to large initial gap

93

Exhibit 36
[ ] Estimate ++ Highly positive

CHINA AUTO FDI IMPACT SUMMARY

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

External Factor impact on


FDI impact on host country
Level of FDI relative to sector*

33%

Economic impact

Level of FDI
Level of FDI** relative to GDP
Global factors

Sector productivity

Sector output

Sector employment

Suppliers

Impact on
competitive intensity

Distributional impact
Countryspecific factors

Companies
MNEs
Domestic

++
0

Employees
Level

Wages

Consumers
Prices

Selection

Government
Taxes

* Average annual FDI/sector value added


** Average (sector FDI inflow/total GDP) in key era analyzed

Sector initial
conditions

Global industry
discontinuity

Per $ impact
of FDI

0.06
O

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

++
O
O
O

O
O
O
O

Macro factors
Country stability

Product market regulations


Import barriers
Preferential export access
Recent opening to FDI
Remaining FDI restriction
Government incentives
TRIMs
Corporate governance
Taxes and other

+
O
+

O
+
O
O

O
O

O
O

Capital deficiencies

Labor market deficiencies

Informality

Supplier base/
infrastructure

Competitive intensity

+ (L)

O (L)

++ (H)

+ (H)

Gap to best practice

94

India Auto Sector


Summary
EXECUTIVE SUMMARY
Until a decade ago, the auto sector in India had been a highly protected industry
restricting the entry of foreign companies, with steep tariffs against imports.
Domestic companies, HM and PAL, had monopolistic domains and operated at a
fraction of the productivity of global best practice companies. Consumers were
forced to pay high prices for outdated and poorly produced products and industry
size was severely restricted. In 1983, the government permitted Suzuki, the lone
FDI company, to enter the market in joint venture with Maruti, a state-owned
enterprise. Ten years later, as part of a broader move to liberalize its economy,
India fully opened up the entire sector to FDI, and since then has also
progressively relaxed import barriers. Today, almost all of the major global
companies are present in India producing cars in all segments, although small
cars account for 85 percent of the market by volume.
FDI has had a strong positive impact on India's auto industry. The productivity of
the industry has increased five-fold and almost all of the benefits have flowed to
consumers. Prices have declined at an average rate of four to six percent annually,
and several dozen new models have been introduced. As a result of rising
productivity, declining in prices and rising incomes, the industry has experienced
explosive growth. India now produces 13 times more cars than it did in 1983 and
has become an exporter of automobiles. India has developed a world-class
components industry, witnessing annual exports growth in excess of 40 percent.
FDI created a powerful impact on India's auto industry not just by contributing
capital, technology, and managerial best practices but also by introducing intense
competition that led to the exit of low productivity companies and pushed
incumbents to improve their productivity dramatically. FDI's impact has been much
more pronounced in the small cars segment, where productivity is growing rapidly
as FDI and Indian companies are forced to innovate design and production
techniques to deliver value to consumers. However, in the larger car segments
where demand is very low, rising productivity improvements have been offset to a
large extent by diseconomies of scale and massive overcapacity.
SECTOR OVERVIEW
Sector overview. India has one of the fastest growing auto sectors in the
world (16 percent CAGR for units produced) manufacturing over half a million
units annually (roughly 1.6 percent of global production) and representing
roughly $5 billion in sales. Of the automobiles manufactured, 85 percent are
in the small car segments. This segment includes smaller and more
economical two-box cars (e.g., the Ford Ka). The industry has shown robust
growth over the past few years, growing at over 15 percent annually by unit
volume. Exports account for a small share of total production but have grown
from a base of zero in 1983 to roughly ten percent of production today.
India's auto industry has historically been a highly closed, supply-constrained
market characterized by poor productivity, poorly produced products, and high

95

96

prices. The sector was liberalized partially in 1983 and subsequently in 1993,
when global OEMs were permitted to make investments in the country
(Exhibit 1). However, even as FDI has been allowed to enter the country, the
sector has remained protected against imports. Tariffs on the import of new
cars are as high as 105 percent, while the import of used cars is prohibited
completely.
Since the opening of the sector to FDI, the industry has gone through
tremendous growth, and has increased competition and improved productivity.
Suzuki's arrival in 1983 introduced limited competition in the industry. The
incumbents (HM and PAL) continued to enjoy patronage from government
purchases and corporate clients, while Maruti-Suzuki began a quasi-monopoly
by creating its own segment. In 1993, the sector was opened to all
international auto companies and the competitive intensity increased
dramatically.
FDI overview. FDI in India auto sector was allowed in two waves: the first was
in 1983, and the second in 1993. Both waves of FDI were market-seeking
(Exhibit 2). Although there was no formal requirement for joint ventures, most
OEMs chose to enter the country with a local partner (Exhibit 3). However, all
joint venture relationships, except that of Maruti-Suzuki, have either been
broken up, or have been diluted subsequently with the share of the Indian
partner reduced to a very minor stake. Suzuki's joint venture with Maruti, a
state-owned enterprise, is a highly successful relationship, as the two
companies bring complementary skills to the table Suzuki as the provider of
capital and technology and the state-owned enterprise us a facilitator of
bureaucracy.
To isolate the impact of FDI on the sector, we have calibrated the performance
of the industry across two distinct phases of FDI:
Restricted FDI (1983-1993). FDI in the auto sector was first allowed in
1983, when Suzuki was invited to enter India as a minority stakeholder in a
joint venture arrangement with the government. Of the several potential
joint venture partners then courted by the government, Suzuki was the only
OEM who agreed to the conditions and was willing to make a capital
investment of $260 million. Other local companies were prevented from
making similar arrangements with international auto companies.
Mature FDI (1993-to present). Subsequently, the sector was opened to
global companies in 1993 and roughly $1.6 billion has been invested by
OEMs to date (Exhibit 4). However, following the 1993 liberalization, it was
still nevertheless heavily regulated, requiring multinational companies to
achieve localization in a specified period of time, make specified capital
investments, balance foreign exchange flows, and meet export obligations.
These restrictions are progressively being relaxed, but the sector remains
regulated.
External factors that drove the level of FDI. India's market potential,
combined with the 1993 regulatory liberalization, attracted FDI into the
industry. This brought in new OEMs and required the existing OEMs to make
capital upgrades.
Country-specific factors. There were several country-specific factors that
drove the level of capital infused into the industry.

97

Exhibit 1

FDI WAS ALLOWED INTO THE AUTO ASSEMBLY SECTOR IN 2 WAVES


Wave 1 Suzuki Era
1983-93

Closed market 1947-83


Characteristics

Closed market (licensing)

Joint venture between


government of India and
Suzuki in 1983 (Maruti)

Output growth limited by


supply

Models were versions of

Wave 2 Transition to
open market 1993-2003

Passenger car production


delicensed in 1993

Most major MNCs started

JVs with Japanese

operations in India to
manufacture existing products
developed for other markets

companies in commercial
vehicles and parts

European cars unchanged


for decades

Existing Suzuki product

Imports allowed on a

transplanted in India
Players in
passenger
car segment

commercial basis since 2001


with very high tariffs

PAL
PAL

Production
(Units)
Domestic sales
(Units)
Exports
(Units)

43,558 in FY 1982-83

273,305 in FY 1994-95

559,878 in FY 2001-02

43,558 in FY 1982-83

163,302 in FY 1994-95

564,113 in FY 2001-02

28,851 in FY 1995-96

50,108 in FY 2001-02

Negligible

Source: EIU; SIAM; Interviews; McKinsey Global Institute

Exhibit 2

MARKET-SEEKING OBJECTIVES WERE THE PRIMARY


MOTIVE FOR INVESTMENT IN INDIA AUTO SECTOR
Description

Every auto major begins to look at emerging markets to


Globalization
Globalization
Hype
Hype

Market
Market
Potential
Potential and
and
Growth*
Growth*

spur growth

Need to not be left out as competitors move overseas


Almost 2 million households that can afford cars
represent a large, untapped opportunity

Market was growing at 13% in 1992-93 with a total


demand of 165,000 units

Very substantial import tariffs meant succeeding in the


Trade
Trade Barriers
Barriers

Emerging
Emerging
components
components
industry
industry

Indian market virtually required local manufacturing and


parts sourcing

Existence of strong local component suppliers set the


foundation for lower costs through localization

Success stories of local players allowed OEMs to


convince global suppliers to enter India simultaneously

Marutis incredible success in India demonstrated the


Marutis
Marutis
success
success

potential of the Indian market and provided a living case


example of how to succeed in India

* Main reason for Wave 1


Source: McKinsey Global Institute

High
Low

Importance for
attracting FDI

98

Exhibit 3

MOST MNCs ENTERED INDIA THROUGH EQUAL JVs, BUT


SOON ACQUIRED MAJORITY STAKES

With Local
OEMs
FordMahindra
GM-CKB
Honda-Seil

Rationale

Outcome

Key Learnings

Mitigate risks associated

Foreign partner acquires

Goals and objectives off

with a new unfamiliar


market
Understand local market
and conditions through
experienced eyes
Leverage strengths of
local player

majority stake when local


partner is unable to bring
in additional capital
Ford increases stake
from 51 to 85%
Honda increases stake
from 40 to 95%
GM increases stake
from 50 to 100%
Local players unable to
absorb initial losses

all players should be


clearly aligned
By definition,
partnerships tend to be
short-term in nature

Partnership continues to

Clearly defined roles and

3 types
of JVs
With government Government backing
vital to create market
Maruti-Suzuki
(and volumes),
overcome infrastructure
constraints and develop
ancillary industries

exist after 20 years


Suzuki gradually allowed to
increase ownership
Increased stake from 26
to 54.1% in 2002/03

responsibilities essential

Government intervention
in management should
be minimal to prevent
additional complexity

With Local non- Mitigate risks associated


Jury still out as venture is
OEM firms
with a new unfamiliar market relatively new
Toyota-Kirloskar Strong match of
Toyota increased its
personalities, goals and
stake from 74 to 99%
objectives
leaving Kirloskar with an
option to buy back 25%
in the future
Source: McKinsey Global Institute

Exhibit 4

SIGNIFICANT AMOUNT OF FDI FLOWED INTO INDIA


ONCE THE SECTOR WAS LIBERALIZED
Annual foreign direct investment*
$ Millions
1800
1600

1997
Fiat begins investment
$455 million

1400
1200
1000
800
600
400
200

1994
Daewoo begins
investment of $1.3
million
Daimler Chrysler
begins investment
of $54 million
General Motors
begins investment
of $223 million

1999
Ford begins
investment of
$433 million

1995
Honda begins
investment of
$120 million

1996
Hyundai begins
investment of
$456 million

0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Note: Suzuki invested $260 million in 1982-83
* FDI for entire transportation sector which includes 2 wheelers, commercial vehicles and tractors
Source: Foreign Investment Promotion Board

99

Sector market potential. The growth of the Indian market has been
fueled by tapping into potential demand that had until then been latent.
However, market penetration, relative to countries with similar levels of
GDP per capita, remains one of the lowest in the world. At Indian prices,
less than 10 percent of households can afford a car (Exhibit 5), which is
well below the levels of penetration seen in other countries at similar level
of economic development. This has led OEMs to invest more modest
amounts of capital relative to markets such as China. Analysts estimate
that the industry can grow to two million units annually if OEMs can
achieve lower prices.
Government policies. Several policies mandated by the government have
influenced the level of capital infused in the industry:
Recent opening to FDI. A high volume of FDI infusion within a short
period of time was driven primarily by the removal of barriers to FDI.
OEMs had for some time assessed India as a lucrative market but were
prevented from investing into it. With the removal of these barriers, the
race to invest in India began.
Import barriers. High import tariffs have required OEMs selling very small
volumes (e.g., Daimler-Chrysler) to set up plants in India when they would
have preferred to access the market through exports instead (small
volumes create large production inefficiencies).
Local content requirements. Local content requirements forced OEMs
and their suppliers to invest larger amounts of capital in order to meet the
local content requirement of up to 70 percent and to meet the need for
balancing foreign-exchange flows.
Government incentives. Although incentives did on the margin impact
location decisions of OEMs within India, there is no evidence of incentives
driving the flow of capital into the country (Exhibit 6).
Poor Infrastructure. Poor state of power, transport, and communications
infrastructure, particularly for delivering components efficiently
discouraged OEMs from making investments initially.
Sector initial conditions. As competition began to heat up with the entry of
global OEMs, Maruti-Suzuki which had relatively lower level of automation
was forced to improve productivity by infusing more capital.
FDI IMPACT ON HOST COUNTRY
Overall impact from FDI on Indian auto industry has been highly positive. In
addition to providing much needed capital, FDI infused new technology and
management skills in an industry a need that could not have been fulfilled by
domestic capital efficiently (Exhibit 7).
Economic impact. Sector performance as measured in output and
productivity growth has grown steadily since 1993 when the industry was
opened to the second wave of FDI. However, employment has declined
marginally.

100

Exhibit 5

VERY SMALL PERCENTAGE OF INDIAS POPULATION CAN


AFFORD A PASSENGER CAR
Income level (Rs. 000); Number of Households (000), 2001-02
Share
Percent

CAGR 1992/93
to 2001/02
Percent

56.0

-1

34.0

8.0

2,248

1.0

1,000-5,000 1,357

0.7

0.1

<70

100,633

61,031

70-200

15,222

200-500

500-1,000

>5,000

201

Less than 10%


of households
can afford a car
Average
threshold gross
household
income is
Rs. 361,000

Source: NCAER; Cris-Infac; McKinsey Global Institute

Exhibit 6

STRONG SUPPLIER BASE AND AVAILABILITY OF SKILLED LABOR ARE


KEY FACTORS IN MNC LOCATION DECISIONS (FORD EXAMPLE)
Ford was offered a host of incentives to locate
its plant in Tamil Nadu
Government offered Ford
Cheap land

300 acres of freehold land at a


subsidized cost of Rs. 300 million

However, incentives were not the most


important factor driving their location decision
Rankings of factors affecting location decision
10=highest 1=lowest
Rank

Infrastructure
assistance

Fiscal
incentives

Guaranteed power supply plant will get


power from 2 separate stations (one
being a 230kV)
Ford to get 40% discount on power tariff
in Year 1 although this was gradually
eliminated by Year 5
Adequate piped water supply assured

Distance from international airport

Proximity to target market

Availability of cheap land

Proximity to port/inland container terminal

14-year holiday on sales tax

Incentives

Availability of infrastructure

Availability of skilled labor

Availability of supplier base (ancillary unit)

(now 12%) on cars sold within Tamil


Nadu (~9% of total production)
Holiday on 4% CST on all cars
sold outside Tamil Nadu
Concession on sales tax levied on
bought-out components in production
process
No import duty on capital goods (~30%
at that time) as long as Ford made a
commitment to export 5 times the value
of the duty (subsequently changed)

Note: Taken from Study on policy competition among states in India for attracting direct investment by R. Venkatesan
et al
Source: Interviews; NCAER

101

Exhibit 7

FDI WAS NECESSARY TO JUMP START THE INDIAN AUTO INDUSTRY


Problems

How FDI helped

FDI brought with it new manufacturing


Outdated
Outdated
technology
technology

techniques and practices


Local players producing cars based on
outdated technologies forced to revisit
operations
New products introduced in new categories

FDI brought sufficient capital to build


Lack
Lack of
of capital
capital

Insignificant
Insignificant
components
components
industry
industry

modern plants
Suzuki chosen over Dahitsu largely
because of their willingness to invest
capital
JVs in Wave 2 continue to rely on
foreign partners for capital

FDI (both) led to the rapid emergence of the


components industry, as players began to
look at outsourcing to reduce costs

Source: McKinsey Global Institute

Results

New products unleashed

latent demand
Category B (smaller car
segment) created which
drove growth
Prices fell as quality
improved while costs reduced

Modern plants built to scale


increased supply and overall
efficiency and productivity

Cheaper components
reduced overall prices and
stimulated demand

102

Sector Productivity. To isolate the impact of FDI, we compared passenger


auto productivity growth in the two phases defined above. The comparison
shows that FDI has contributed to raising both the rate of productivity growth
the productivity level.
Growth. Labor productivity has grown at a staggering annual rate of 20
percent since the sector was opened to FDI in 1993 (Exhibit 8). This
growth was driven primarily by the exit of the low productivity company,
PAL, and by productivity improvements at incumbents HM and MarutiSuzuki (even as their capacity utilization declined) (Exhibit 9). Our
interviews indicate that the continuing rapid productivity growth in these
players was driven by the increasing competitive intensity (Exhibit 10).
Level. FDI companies on average are 38 percent as productive as U.S.
plants, while non-FDI companies achieve productivity that is only
5 percent of the U.S. plants. Maruti-Suzuki, the highest performing
company in the industry, has a productivity more than 50 percent that of
U.S. plants (Exhibit 11).
Sector productivity has remained at less than its full potential. Most
multinational companies achieve productivity levels significantly lower
than they do in their home country. This is not only due to their suboptimal scale in India (Exhibit 12) but also to a glut in capacity. The
industry has 40 percent overcapacity as a result of OEMs overestimating
demand and making excessive investments.
Sector Output. Output by volume in the industry has grown lockstep with
the FDI-infusion in the industry. In the decade prior to 1983, when there
was no FDI, output grew at a rate less than one percent a year. From 1983
to 1993, following FDI from Suzuki, industry output grew at 13 percent
annually. From 1993 to date, in the period of mature FDI, output has grown
at over 15 percent annually (Exhibit 13).
Sector Employment. While employment has grown at healthy rates for most
OEMs during our focus period (eight percent CAGR at Maruti-Suzuki,
accounting for 25 percent of industry employment), overall employment in
the sector has declined marginally (by one percent CAGR). This decline has
been driven by the forced exit of the lower productivity company PAL while
other OEMs were adding jobs.
Supplier spillovers. The most prominent spillover impact of FDI in India's
auto sector has been on the components industry.
The components industry more than tripled in size (Exhibit 14) during the
period of review as new car sales boomed and assemblers outsourced
more of their cost base to improve productivity. Outsourcing by OEMs to
components manufacturers has greatly increased from the minimal levels
in the pre-FDI period (Exhibit 15).
Several international components companies have entered the sector to
serve the international companies and competition has intensified as a
result. Components manufacturers have been forced to increase quality
and reliability and dramatically improve their performance and quality
(Exhibit 16).

103

Exhibit 8

LABOR PRODUCTIVITY IMPROVED WITH MORE FDI


Equivalent cars per equivalent employee 1999-00; Indexed to India = 100 in 1992-93
Output

CAGR
21%
100

Labor productivity

1992-93

380

1999-00

356

CAGR
20%
100

y
Employment

1992-93

1999-00
CAGR
1%
100

1992-93

111

1999-00

Source: Interviews; SIAM; Annual reports; McKinsey Global Institute

Exhibit 9

FDIS MOST CRUCIAL IMPACT WAS TO INDUCE MARKET REFORM


Labor productivity
Equivalent cars per equivalent employee; indexed to 1992-93 (100)
PAL produced 15,000 cars* and
employed 10,000 employees* while
Maruti produced 122,000 cars* with
4000 employees* in 1992-93

Increased automation,
innovations in OFT and
supplier-related initiatives
drove improvement

Less productive than Maruti


mainly due to lower scale and
utilization (~75% of the gap)

84

356

156

Increase primarily
driven by indirect
impact of FDI that
increased
competition and
forced improvements
at Maruti

144
100

38

Productivity in Improve1992-93
ments at
HM

Improvements at
Maruti

Exit of PAL

Indirect impact of FDI


driven by competition
* Actual cars and employment (not adjusted)
Source: MGI; McKinsey Global Institute; team analysis

Entry of
new
players

Productivity in
1999-00

Direct impact
of FDI

104

Exhibit 10

MARUTIS PRODUCTIVITY CONTINUED TO GROW RAPIDLY WITH THE


ENTRY OF FDI
Cars produced per employee
Units
FDI allowed
GR
CA

%
10

9)
199
94(19

63

58

56
)
9
990
GR
6-1
CA
198
(
%
1
1
GR
CA

23

26

29

31

)
994
0-1
199
(
%

30

70

63

43

38
32

1986- 1987- 1988- 1990- 1991- 1992- 1993- 1994- 1995- 1996- 1997- 1998- 199991
87
88
89
92
93
94
95
96
97
98
99
2000
* Total output/total employment (direct + indirect)
Source: McKinsey Global Institute

Exhibit 11

LABOR PRODUCTIVITY IN MULTINATIONAL COMPANY


PLANTS IS SIGNIFICANTLY LOWER THAN IN MARUTI

Share of
industry
employment
Percent

Cars per employee*; Indexed to U.S. average = 100 in 1998


100

52

38

100

Postliberalization
plants, India

100

25

U.S.
average

Maruti

U.S.
average
100

24
100

India
average

U.S.
average

27

Preliberalization
plants, India

U.S.
average

New postliberalization
plants, India

31

U.S.
average
43

* Estimate accounts for differences in level of outsourcing by benchmarking only comparable elements of assembly
Source: Interviews, SIAM; McKinsey Global Institute

105

Exhibit 12

SCALE OF PRODUCTION 1999-00


Thousand cars per plant

408

100
62
25
Indian
postliberalization
plants
without
Maruti

Indian postliberalization plants


without
Maruti at full
utilization*

Minimum
efficient
scale for
Indian
automation

Maruti**

* With two shifts


** Including MUV
Source: Interviews, SIAM, Harbour report

Exhibit 13

DEMAND FOR PASSENGER CARS TRIPLED IN SIZE


WITH FDI AS NEW PLAYERS ENTERED

Closed market 1947-83

Unit sales
FDI

Wave 2 - Transition
to open market
1993-2003

Wave 1- Suzuki Era


1983-93

700000

Overall CAGR
= 14% 19822002

(1
99
302
)

16000

.3
%

10 new players
Over 20 new models*
4-6% real price decline
CA
GR

500000

Car
sales 400000
(Units)

14000
12000

15

600000

10000
8000

300000

GR
CA

200000

%
13

93)
82(19

6000
4000

CAGR 0.7% (1972-82)


100000
0
FY72

2000

FY75

FY78

FY81

FY84

* Does not include multiple variants of same model


Source: ACMA; McKinsey Global Institute

FY87

FY90

FY93

FY96

FY99

0
FY02

FDI
(Rs.
Millions)

106

Exhibit 14

WITH FDI IN ASSEMBLY, THE COMPONENTS INDUSTRY


MORE THAN TRIPLED IN SIZE
Total vehicle production
Units; Thousands
5,287
CAGR
= 10%

Auto Component sales*


Rupees; Crores
CAGR
= 20%

2,261

16,164
1992-93

3,201

2001-02

Share of component
cost outsourced
Percent
64
CAGR
= 10%
1992-93

2001-02
30

1994-95

2001-02

Note: Increase in amount spent per vehicle used as a proxy for increased outsourcing
* Includes component sales to all auto categories - 2, 3, and 4 wheelers (Passenger cars, Utility Vehicles and Commercial Vehicles)
Source:CRIS-INFAC; ACMA; McKinsey Global Institute

Exhibit 15

OUTSOURCING IS ON THE RISE AS OEMS BEGIN TO FOCUS ON


CORE ACTIVITIES
Average outsourcing budget as a percentage
of revenue has been rising

Local content in most leading cars is now over 70%

OEM

Percent
Global
average =
70%

Models

Local content
Percent

98

Indica

64

88

Santro

80

Ikon

59
Palio

58

1998

1999

2000

Note: Maruti has nearly 90-100% local content in most high volume models
Source: ACMA; Infac; news reports; McKinsey Global Institute

75

Astra

70

Qualis

68

107

Exhibit 16

RAPIDLY INCREASING DEMAND, COMPETITION AND HIGHER


STANDARDS FUNDAMENTALLY CHANGED COMPONENTS INDUSTRY
Demand for components increased as new
car sales sky rocketed

As number of players increased so did overall


production
Global suppliers
entered to serve global
auto majors in India

As assemblers began to focus on core activities to


improve financial performance, outsourcing of
components increased

Global majors

encouraged international
players to enter
GM influenced the entry
of Delphi
Ford is bringing Ford
ACG (Auto Component
Group) to India
Toyota has set up a
Toyota Village around
its manufacturing unit to
house its suppliers
Hyundai has an
industrial park where its
global suppliers have
set up base

Established joint

Industry grew by
19% CAGR between
1994/95-2001/02

Performance requirements increase as


price pressure increases

Higher quality components expected by OEMs in


keeping with international standards

OEMs are reducing their supplier base and using


the resulting economies of scale to demand high
price cuts

OEM pressure is forcing suppliers to supply JustIn-Time


Source: McKinsey Global Institute

Domestic players took


strong actions to
improve performance
ventures with leading
foreign companies to
preempt their entry and
to increase overall
quality/image
Made investments in
capacity additions/
upgrades
Improved quality
and reliability

108

Although we have not estimated productivity growth in the components


industry, its emergence as a base for exports ($0.8 billion exports in
2002, growing at roughly 38 percent annually) indicates rising
competitiveness.
Distribution of FDI impact
FDI's impact in increasing productivity, along with increasing the level of
competitive intensity, has ensured that most of the surplus generated is
transferred to consumers and labor. Companies have not managed to retain
the benefits from improved productivity and have been forced to reduce their
margins.
Companies. While the industry has improved its productivity dramatically
with FDI, OEMs have been forced to yield the surplus generated to
consumers and labor. Profitability in the industry has declined measurably
(Exhibit 17) with OEMs in small car segments reducing margins to the global
industry average and those in large car segments losing money (Exhibit 18).
FDI Companies. Despite the fact that many companies are still
performing well by global industry standards, their profitability has
declined from what it used to be before the sector was fully liberalized.
Maruti-Suzuki, the lone FDI-OEM in the first wave, was highly profitable
before competition from FDI. With competition, even as Maruti-Suzuki
has improved its productivity dramatically, it has had to reduce its
margins steadily. Before Hyundai's arrival, Maruti-Suzuki enjoyed profit
margins of 10-12 percent (compared to global average of five percent).
However, after Hyundai's arrival, its margins have come down to 3-4
percent. Other FDI companies especially the American and European
OEMs who have limited or no products to offer in small car segments
are losing money. The only exceptions that are profitable, other than
Maruti-Suzuki, are Hyundai (with a substantial presence in small car
segments) and Honda (with a very small presence).
Non-FDI Companies. Of the main non-FDI companies HM has now has
entered a joint venture with Mitsubishi and PAL has been driven out of
business. This leaves Telco and Mahindra.
Telco, while much smaller than Maruti-Suzuki, is a dominant company in
a smaller car segment (one of the most popular segments in the sector),
where it has one third of the market. Telco has managed to attain this
position by developing a car that it has developed itself, the Indica. This
has been successful with certain customer segments because it is
customized to local needs (e.g., it has lower operating costs).
Similarly, Mahindra has developed in India a localized version of an SUV
that has captured a large share of the market; the product has already
broken even in 2.5 years (well ahead of the industry norm of 6-7 years).
Employees
Level of employment. With the infusion of FDI, overall employment in the
sector in the period under review has declined marginally (by one percent
CAGR). While employment grew at healthy rates for most OEMs during
this period (eight percent CAGR at Maruti-Suzuki, which accounts for
25 percent of industry employment), the decline was driven by the forced
exit of the lower productivity company PAL.

109

Exhibit 17

CONSUMERS BENEFITED THE MOST FROM


MARUTIS IMPROVED PERFORMANCE
Labor productivity increased
dramatically

But profitability declined

As consumers benefited from


falling prices

Equivalent cars per equivalent employee


1999-00; Indexed to India in 1992-93

Annual change in net profits


Percent

Real price change between 1998-2001


Percent

CAGR
13%

Significant
Marutito
investments
upgradeEsteem
and
increase capacity
partially offset
gains in labor
Maruti
productivity

188

1994/95

241

-6

73

1995/96
1996/97

19

1997/98

28

-5

Zen

100
1998/99

-20

1999/00

-37

2000/01
1992-93

Maruti
800

-4

-182

1999-00

Source: Interviews; SIAM; Annual reports; McKinsey Global Institute

Exhibit 18

PERFORMANCE IN THE INDIAN AUTO SECTOR IS


HIGHLY VARIED

NOT EXHAUSTIVE

Market share**
Dominates market with strong
profits until recently when profits
fell due to initial costs associated
with 4 new product launches and
a capacity expansion project

60
50
40

Currently most
profitable and
second largest
in volume

30
20
10
0

Negative
0
5
Operating profit margin*

10

Positive
15

20

* For year entries March 2002 for all players expect maturity and Hyundai where March 2001 numbers used
** For the period April-September 2002
Note: Margin for passenger cars, HCVs and LCVs for Telco
Source: Cris-Infac; McKinsey Global Institute

110

Wages. Although wages at the sector level have not been compiled,
there is strong evidence to suggest that wages have risen with FDI.
Wages at Maruti-Suzuki have risen at 25 percent annually during the
period. Average wages for line workers in the auto industry today are Rs.
120,000-150,000 a year, as compared to an average of Rs. 75,000-Rs.
90,000 prior to 1993. While a large portion of this rise might be related
to the incentive based bonuses at Maruti-Suzuki that have been used to
drive its productivity improvement ahead of other OEMs, it is unlikely that
such dramatic increases in wages at Maruti-Suzuki were isolated from the
rest of the industry.
Consumers
Prices. Prices have declined substantially with the infusion of FDI. Prices
tracked for all segments over the past five years show a steady decline of
8-10 percent annually, even as the consumer price index rose by an
average of 4-7 percent a year in this period (Exhibit 19). As a result,
demand has risen and the industry has tripled in size as cheaper products
in new categories unlocked latent demand and the industry was relieved
of supply constraints.
Product selection and quality. The selection of products has also
improved with FDI (Exhibit 20). Prior to Suzuki's arrival, the industry had
two models in the passenger cars segment. Following Suzuki's arrival in
the 1980s, this climbed to eight. Today, with the mature FDI in place,
the number of products has risen to over (Exhibit 21).
Government. The industry has tripled in size by unit volume with annual
growth rates of 13 percent (Wave 1) and 16 percent (Wave 2), compared
to one percent in the pre-FDI era. Government revenues through taxes on
sales have thereby increased substantially.
HOW FDI HAS ACHIEVED IMPACT
FDI has had a crucial role in improving the performance of the auto sector in India
by changing the industry dynamics and improving operations.
Industry dynamics. The second wave of FDI played a crucial role in altering
the industry dynamics so as to make the industry competitive internationally.
The total number of companies in the industry quadrupled as many major
OEMs entered India (Exhibit 22). The entry of highly productive global OEMs
raised competitive intensity (exhibits 23 and 24) and pushed the incumbent
Maruti-Suzuki into increasing its productivity.
In the first wave of FDI, Maruti-Suzuki's impact in increasing competitive
intensity and raising the productivity of incumbents was limited. MarutiSuzuki created its own segment of customers by tapping into latent demand
for high-quality low cost cars. Production volume for local OEMs did not
suffer as demand still outstripped supply.
Competitive intensity increased with the second wave of FDI as new, more
productive companies entered, and manufacturers greatly expanded product
offerings and competed on price. Sector productivity increased dramatically,
not only because of the arrival of the more productive international

111

Exhibit 19

OVERALL PRICES HAVE DECLINED


Prices*
Rs. Lakhs

CAGR 1998-2001
Percent

10

8
8.0
7.5

Segment D**
(Opel Astra)

-2

Segment C
(Maruti Esteem)

-9

Segment B
(Maruti Zen)

-9

Segment A
(Maruti 800)

-10

6
5.1
4

4.2
3.9
3.0

2
1.6

1.2

0
1998

1999

2000

2001

Note: Prices shown for most expensive model in each segment


* Retail prices adjusted for improvement in quality and for inflation using CPI
** Prices not adjusted for quality
Source: INFAC; McKinsey Global Institute

Exhibit 20

CONSUMERS NOW ENJOY GREATER CHOICE


Product offering 1982*
Engine capacity (cc)

Product offering 1995*

2600

Product offering 2002

2400

Accord

2200
2000

Ambassador

1800

Daewoo
Cielo/Nexia

Fiat
Siena

Opel Astra
Maruti Baleno

Contessa

1600

Maruti Esteem
Ambassador
Tata Indica

1400

1000

Hyundai Accent
Opel Corsa/ Swing
Honda city
Ford Ikon
Premier Padmini
Wagon R

Fiat Uno
Hyundai Santro
Premier Padmini
Maruti
1000

1200

Mercedes E
Class

Hyundai
Sonata

Mitsubishi
Lancer

Fiat Palio

Maruti Zen

800

Alto

600
Maruti
Omni

400

Maruti
800

Daewoo Matiz

200
0
0

10

11

12

13

14

15
35

Price (Rs. Lakhs)


* Retail prices adjusted for inflation using Consumer Price index (not auto specific) ; excludes 2 models by PAL (Padmini and 118NE)
which together accounted for ~13% of the market
Source: Autocar India, Lit search; McKinsey Global Institute

112

Exhibit 21

FDI SPURRED INDUSTRY GROWTH BY CREATING NEW


PRODUCT SEGMENTS
Market size by category
Units
515,634
950

1,907

71,237

3,755
35,845
9,502
43,558

Luxury (E)
3-box high-end (D)
3-box economy (C)

279,996

2-box high-end (B)

158,946

2-box economy (A)

202,107
0

153,005

Market
growth
driven
primarily by
growth in
segments A
and B since
1982/83

0
Closed market

Suzuki era

Liberalization

Sales figures
for FY

1982-83

1994-95

2001-02

Number of
models in
market*

28

* Excluding multiple variants of a model


Source: CRIS-INFAC; ACMA; McKinsey Global Institute

Exhibit 22

INCUMBENTS LOST SIGNIFICANT MARKET SHARE AS


COMPETITION INTENSIFIED
Number of players
12

4x

Passenger car sales by players


Percent; Thousands
100% =

44
0

163
0

542

46

Post 1993 MNCs


Mercedes
Telco
Mitsubishi
Ford
Honda
GM
Skoda
Daewoo
Fiat
Hyundai
Peugeot**

77
1992

Maruti
HM
PAL

2003

Maruti
Hyundai
Telco
Daewoo
HM
Honda
Ford
GM
Skoda
Toyota
Fiat
Mercedes

100

51

Maruti-Suzuki

23
3
FY 83

FY 93*

* Excludes 3,937 (2% of total category) units sold by Telco


** No longer in business
Source: CRIS-INFAC; SIAM; McKinsey Global Institute

FY 03

Original domestic players


Hindustan Motors
PAL**

113

Exhibit 23

FDI INCREASED INDUSTRY COMPETITIVE INTENSITY


Indicators of
competitive intensity

Degree of
intensity

Comments/Observations
12 new players entered since 1993 when the auto assembly sector

New entrants
(contestability

was liberalized

New players now account for nearly half the market


PAL exited in 1999-2000 as demand for its outdated Padmini model

Weak players
exit

(designed in the 60s) vanished

PAL-Peugeot also exited as demand failed to pick up


Daewoo disappeared as consumers stopped buying its cars on
concerns over the future availability of spares and service support

Incumbents like Maruti and Hindustan Motors have steadily lost

Market position
turnover

share as new players grabbed share with better product offerings

Share has continuously shifted between new players since 1994 as


new models were introduced and prices fell

Real prices have fallen for all categories as overcapacity forced

Role of price*

players to drop prices

On average, real prices have declined 2-6% between 1998 and


2001

Moreover if quality improvements were to be factored in, prices


would have fallen even further

Sector level profitability has declined by 25% CAGR between 2001-

Profitability*

02 largely due to real price declines

At a player level, more productive players (e.g. Hyundai) have seen


profitability increase while most others have suffered as volumes
declined
* Covered in earlier section
Source: McKinsey Global Institute

Exhibit 24

SEGMENTS A AND B HAVE BEEN IMPACTED THE MOST BY FDI


Degree of competitive intensity

A/B (smaller car)

Very high

Maruti practically invented the


A category by introducing the
800
Although Ambassador and
Premier Padmini (2 cars sold
when Maruti entered) were not
A/B cars by length, they fell
into this category based on
their price

Segment B which accounts for


nearly half the total market
saw the entry of Hyundai,
Daewoo (now closed) and Fiat
which brought superior
products
Several MNCs now launching
new products including Honda
and GM

Medium

C/D/E (larger car)

Segments

Medium

Although several players


compete in these segments,
volumes are very small (~15%
of the total market)
Given limited demand, most
players suffer from very low
capacity utilization

Wave 1

Wave 2
FDI Phases

Source: McKinsey Global Institute

High
Low

114

companies (the product mix effect) but also because weak companies exited
and incumbents were forced to improve (the low-productivity company PAL
exited, while HM fundamentally changed its role to become an outsourcer
to Mitsubishi).
Operational Factors. Both waves of FDI have had a strong impact on
operations in the sector.
Capacity expansion. Prior to the arrival of Suzuki, the Indian auto industry
was highly supply-constrained. In the first wave of FDI (the Maruti-Suzuki
joint venture), FDI provided capital and increased production capacity. The
impact of this increased capacity was positive on industry productivity
through improved economies of scale (Exhibit 25). This allowed the industry
to offer better products at low prices, unleash latent demand and virtually
create the Indian auto industry. By contrast, the impact of increased
capacity on productivity in the second wave of FDI was negative, as OEMs
created 40 percent overcapacity, which dragged down sector productivity
and profitability (Exhibit 26).
Improved products. Innovation in the industry soared with FDI. Prior to the
arrival of FDI, the industry offered only two models and had offered no new
products for decades. With Suzuki's arrival in the 1980s, this number
climbed to eight. Today, with the mature FDI in place, not only has the
number of products risen to more than 30, but product quality is at
international levels and is being exported to the multinational company's
home markets (Exhibit 20).
Management practices. The first-wave of FDI had a direct impact on
improving the productivity of the industry as Suzuki brought superior
production and management skills to India. In contrast, the second-wave of
FDI impacted management and production skills through both direct and
indirect means. It did so directly, as high-productivity FDI companies such
as Hyundai increased industry productivity built scale and captured market
share. FDI had an even greater impact indirectly: Maruti-Suzuki was forced
to revamp its production template and increase its productivity at an annual
rate of 10 percent (exhibits 25 and 27).
Supplier industries. FDI has also contributed to improving the productivity of
auto sector in India through upstream positive spillover effects. This impact
has been achieved in two distinct ways.
Improving productivity of suppliers. Although productivity data are not
available, interviews with OEMs and secondary indicators (falling prices,
improved quality, rising exports) indicate that the productivity of the
supplier industry has improved substantially with FDI. This was achieved
in two ways: first, FDI-OEMs co-located suppliers and transferred best
practice techniques; second, FDI-OEMs required their home country
suppliers to make FDI investments in India, introducing similar dynamics
in the suppler industry to those described in the auto sector.
Enabling further FDI in assembly. FDI enabled the creation of a reliable
supplier industry. This in turn has been responsible for attracting further
FDI investments from OEMs and has set a virtuous cycle of improvement
in motion, as OEMs have helped improve the productivity of suppliers,
while a high-performing suppler industry has helped improve OEM
productivity.

115

Exhibit 25

LOWER PRODUCTIVITY OF MNCS LARGELY DRIVEN BY


LACK OF SCALE AND POOR UTILIZATION
Equivalent cars per employee*, indexed to U.S. average
52
19
27

22
5
Pre-liberalisation
plants

Excess
workers,
OFT, DFM,
techno-logy

Post-libera- Skill
lisation plants
(excl. Maruti)

Supplier
relations

Less

Less JIT
experience Lower
product
quality

Causes

Scale/
Utilization

Maruti

Less
indirect
labour per
car produced
Higher
output

* Excluding sales, R&D, powertrain, etc., and adjusted for hours worked per year
Source: Interviews, SIAM, INFAC; McKinsey Global Institute

Exhibit 26

OVERCAPACITY IN THE INDUSTRY HAS LED TO LOWER PROFITS


Assembly capacity and production
of cars and UVs
2001, thousands

Excess capacity
Production

40%
40%
overcapacity
overcapacity
100
64
110

82

25

30
20

25
17

10 1,182
9

29
26

-25%
-25% CAGR
CAGR

41

38

120
113 38
160 56

50

50

Operating profit before interest, depreciation


and tax, for major car and UV assemblers*
Rupees Million

20

67

16

350 84
479
348

MUL Tel- M&M Hyu- Dae- HM Fiat Ford Toy- Hon- GM Merc-Total
ota da
edes
co
ndai woo &
MitsuBenz
bishi

1996-97

1997-98

1998-99

2000-01

2001-02

* Includes Bajaj Tempo Ltd., Daewoo Motors Ltd., Hyundai Motors India Ltd., Hindustan Motors, M&M, MUL & Telco
Note: Operating profit is net sales less operating expenses
Source: INFAC; SIAM; CMIE Capex; Prowess; McKinsey Global Institute

116

Exhibit 27

PRODUCTIVITY INCREASES DRIVEN BY SEVERAL FACTORS

High
Low

Examples of what they did

Robots in body shop increased (300 robots now)


Increased
Increased
Automation
Automation

Process
Process
improvements
improvements

Suppliers
Suppliers

indigenously developed robots costing ~$50,000 had a


payback period of ~5-8 years given high labor costs
(~$400 per worker)
Use of automatically guided vehicles in material handling
Transfer of 8 sets of dies from semi automatic to
automatic presses (replacing 18 people)
Several innovative production practices which drastically
improved quality resulting in optimal utilization of
production lines (examples to follow)
Shop floor layout improved (e.g. gap between stations
reduced) over 35,556 sq. meters between 1997/98 and
1999/00
Kaizen Quality Circles initiated to encourage worker
participation (Over 140,000 suggestions implemented
since 1995/96)

Sourcing more sub systems from suppliers


Number of suppliers reduced from 375 to 299 by
removing all dormant/inactive vendors and retaining only
high performers
New ventures aimed at increasing overall capacity
Maruti and Machino Techno Sales set up a Rs 400m
($12.7m) steel metal stamping shop near Delhi that
that augmented Maruti's steel metal pressing capacity
with an 800-ton press line, possibly rising to 1,200
tons

New plant added with a capacity of 100,000 units (2


Capacity
Capacity
addition
addition

shifts) with minimal new labor (labor mostly redeployed


from existing plants)

Source: Interviews; McKinsey Global Institute

Impact on
productivity

How it helped

Output increased due to higher productivity


Less rework as quality improved

Overall speed of line increased


Less rework as quality improved

Lower complexity resulted in higher reliability


and lesser downtime

Move towards more sub assemblies allowed


existing labor to be redeployed to increase
line speed / capacity

New partnerships helped increase overall


capacity without significant increase in labor

Currently running one shift, this new plant


increased overall capacity by 50,000 units
accounting for a fifth of the total increase in
output

117

EXTERNAL FACTORS THAT AFFECTED THE IMPACT OF FDI


FDI made a very positive contribution to the industry by infusing capital and
technology and by creating a competitive industry dynamic that forced incumbents
to reform or exit. Although FDI's impact was very strong, certain factors external
to the industry did dampen its full potential. For example, local content
requirements forced OEMs to set up subscale component manufacturing plants in
India, or find informal ways to source imports while showing them as sourced
locally7. While it may be argued that on the margin this accelerated the
development of a component industry8, in the short run it increased the cost of
producing autos in India and reduced demand. Similarly, high import tariffs forced
OEMs to setup subscale operations in larger car segments, while high domestic
taxation suppressed demand and exacerbated overcapacity. In addition, labor
regulations prevented the rationalization of employment, poor infrastructure led to
production inefficiencies and larger inventories, and overcapacity in production for
larger size cars have all prevented MNCs from achieving their full productivity
potential.
SUMMARY OF FDI IMPACT
Overall, FDI on the host country has been very positive. In an industry where
global scale has traditionally been necessary to develop world-class products, FDI
has been crucial in reinventing India's formerly under-productive auto industry. FDI
not only fulfilled this direct need in India, but also set in motion dynamics that
have resulted in a dramatic impact on the industry from upstream spillovers to
increased competitive intensity that forced incumbent OEMs to improve
productivity. With FDI, the industry has increased its productivity several-fold and
tripled its output over the past two decades. Benefits of the surplus generated
have largely flowed to consumers (in the form of better, cheaper products and
increased choice) and, to a lesser degree, to labor (in the form of increased
wages). The government also benefited from higher tax revenues. However, to
date, the losers have been OEMs themselves the very agents that have driven
these changes.

7.

8.

Through our interviews, we learned that some OEMS sourced components from local
manufacturers who had actually imported them but found ways to show them as having been
produced locally.
We found it difficult to make a convincing case that local content requirements led to the
development of a mature components industry in India. Our research shows that while local
content requirements may have marginally accelerated the development of India's component
industry, it should not be seen as a direct result of these requirements. OEMs believe that they
would have sourced components locally in any case because: 1) Given India's poor
transportation infrastructure (ports, highways, rail freight) local sourcing was the only option to
leverage Just-In-Time. Importing components would have been virtually impossible and
increased costs prohibitively. 2) Following the Rupee's devaluation in the late 1980s and early
1990s, OEMs were forced to start sourcing components locally. If they had not they would have
been driven out of business by the rising costs of imports (as happened in the LCV segment).
3) Given India's cheap, technically trained labor, it also makes organizational sense to
manufacture components locally.

118

Exhibit 28

INDIA AUTO SUMMARY

External
factors

Indias potential large market and relaxation of FDI regulations explain the
headlong rush of OEMs into India after 1993. Prior to this, Suzuki was the
only MNC permitted in the country

Indias licensing policy had for decades protected a duopoly of highly


inefficient domestic players and constrained supply. Innovation was rare
and shoddy products were sold at high prices. There was large latent
demand as consumers were unable to afford what the industry offered

Suzukis JV entry in 1983 unleashed this latent demand by introducing a


high performance product at low price. With further liberalization, highly
productive MNCs like Hyundai entered the country driving competitive
intensity particularly in segments A/B
As a result, new products were introduced and prices declined. Pre-FDI
incumbents lost market share rapidly and weak players exited (PAL)
Some highly capitalized domestic conglomerates also entered, introducing
indigenously developed products and captured market share from MNCs
Overestimating demand, MNCs created a large overcapacity in segments
C, D, E (larger car segments)

1
2

FDI

Industry
dynamics

4
5

Operational
factors
6

Sector
performance

Intense competition in segments A/B (smaller car segments) drove


innovation as OEMs like Maruti dramatically improved their productivity by
automating plants with indigenous technology, revamping OFT and
improving labor skills
Domestic champions like Telco and Mahindra optimized labor/capital tradeoffs and superior local knowledge to develop indigenous products at a
fraction of the cost of global OEMs and produce them cheaply
Segments A/B: FDI improved productivity of the Indian industry by
contributing knowledge and technology. Productivity of best practice FDI
player Maruti is 10 times of pre-FDI domestic players
Segments C/D/E: Even as MNCs contribute knowledge and technology,
they drag industry productivity down due to sub-optimal scale and severe
overcapacity
Overall FDI impact on the host country has been very positive
Sector productivity increases several-fold and consumers benefit from
greater choice and lower prices while employment remains flat

Source: McKinsey Global Institute

Exhibit 29

INDIA AUTO FDI OVERVIEW


FDI periods
Focus period: Mature FDI

1993-2003

Comparison period: Early (only Suzuki) FDI

1983-1993

Total FDI inflow (1993-2000)*

$1.5 billion

Annual average

$216 million

Annual average as a share of sector value added**

NA

Annual average per sector employee**

$1,000

Annual average as share of GDP**

0.05%

Entry motive (percent of total)


Market seeking
Efficiency seeking

100%
0%

Entry mode (percent of total)


Acquisitions

0%

JVs

82%

Greenfield

18%

* FDI for entire transportation sector which includes 2 wheelers, commercial vehicles and tractors
** 2001
Source: Foreign Investment Promotion Board

119

Exhibit 30

INDIA AUTO FDI AND ECONOMIC IMPACT IN


HOST COUNTRY

Sector

Early FDI
Mature FDI
(1983-1993) (1993-2003)
++

20%

++

Sector output

Negative
Highly negative
Estimate

Evidence

Wave 1 of FDI drove productivity of the industry by mix-effect from


the entry of a highly productive player like Suzuki

1%*

13%

13%

21%

which drove Maruti to further dramatically increase its productivity. It


also forced the exit of unproductive incumbents like PAL

++

FDI increased output of the industry through 2 key drivers:


Increased supply to match existing unmet demand
Create additional demand by introducing new products at reduced
prices that tapped latent demand in the market

1%

employment
(CAGR)

Suppliers

Positive

Wave 2 of FDI was the key driver of increased competitive intensity

(CAGR)

Sector

Highly positive
Neutral

[ ]
FDI
impact

productivity
(CAGR)
Maruti

Sector performance
during
Economic
impact

++

Increased competition from FDI resulted in the exit of employmentintensive player PAL. However, adverse impact on employment was
offset by a proportional increase in output by MNCs

++

++

MNCs required their suppliers to setup base in India and helped build
a mature supply chain. Impact of upgrades in quality has allowed
Indian components manufacturers to become large exporters and the
industry has grown at 13% per annum since 1998

Impact on
competitive intensity
(net margin CAGR)

25%
Increase
(89-93)

~25%
Decline
(96-02)

++

FDI brought all major OEMs into the country and created 40%
overcapacity in the industry. As OEMs fought to maintain market share,
profitability declined even as productivity increased

*1990-92
Source:McKinsey Global Institute

Exhibit 31

INDIA AUTO FDIS DISTRIBUTIONAL IMPACT IN


HOST COUNTRY

__
[ ]

Sector performance
during
Economic
impact

Early FDI
(1983-1993)

Mature FDI
(1993-2003)

++
+

FDI
impact

Evidence

Companies
FDI companies

Non-FDI
companies

25%
Increase
(89-93)
_

~25%
Decline
(96-02)
__

__

Due to intense competition, MNCs were forced to pass on more than


what they gained through productivity increases to consumers

In addition to reducing prices and profitability, domestic companies


also lost market share to MNCs in all categories (Does not include
TELCO a new domestic entrant in the passenger car segment
that has successfully captured ~11% market share in 3 years)

Employees
Level of
employment
(CAGR)

1%

Increased competition from FDI resulted in the exit of employment-

Wages

++

Marutis wages increased at 25% CAGR between 1993-2000;

++

Intense competition resulted in OEMs transferring all gains in

intensive player PAL. However, adverse impact on employment


was offset by a proportional increase in output by MNCs
Maruti accounts for over 20% of sector employment*

Consumers
Prices

productivity to consumers

Selection

++

++

With FDI, number of models available increased dramatically

Government

++

++

Increased revenue due to taxes levied on cars likely to outweigh

Taxes

lost taxes on company profits

* Both waves of FDI resulted in wage increases Maruti, which currently pays the highest wages in the industry,
entered in Wave 1, and pressure from Wave 2 players resulted in higher wages due to higher productivity
Source:McKinsey Global Institute

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

120

Exhibit 32
High due to FDI
High not due to FDI

INDIA AUTO COMPETITIVE INTENSITY


Sector
performance during
Pre- Wave 1 FDI
(1993)

Low
Wave 1 FDI
(2003)

Pressure on
profitability

Evidence

Rationale for FDI


contribution

Marutis rising profitability has

Competition/increased choice and

steadily been declining since


1993; All MNCs (excl. Hyundai)
making losses
13 new entrants since 1993

New entrants

overcapacity have forced OEMs to


squeeze margins in all segments

Of the 13 new entrants,


12 are MNCs

3 weak player exits out of a

PAL (domestic), Peugeot and Daewoo

total of 13

Weak player exits

exited as higher productivity OEMs


offered better products at much lower
prices
Real prices of MNC products fell in
all categories as competition
increased

Real prices for products


have been declining steadily
across the board

Pressure on prices

Dramatic changes in market

Changing market
shares

Maruti steadily lost share (from 80%

share as more productive


players enter the market

to 50%) to Hyundai and other MNCs


in addition to Telco, a domestic
player

OEMs are constantly

Pressure on product
quality/variety

FDI players have further

introducing new products in


the market

Pressure from
upstream/downstream industries

Overall

broadened SKU
selection

N/a

N/a

Intense competition in the

Prior to FDI, the market

industry, especially in segments


A/B

was an uncompetitive
and protected oligopoly

Source: McKinsey Global Institute

Exhibit 33

INDIA AUTO EXTERNAL FACTORS EFFECT


ON FDI
Impact on
level of FDI Comments
Level of FDI*
Global
Global industry
factors
discontinuity

Countryspecific
factors

++ Highly positive

Highly negative

( ) Initial conditions

Impact
on per
$ impact Comments

Na
O

Negative

+ Positive
O Neutral

Relative position
Sector market size
potential

Prox. to large market

Labor costs

Language/culture/time

Players attracted to large population, although


less than 0.2% (400,000) HHs can afford a car

Lack of demand has resulted in ~40% overcapacity in


industry

Lower labor costs allow OEMs to substitute labor with


capital to reduce costs, while cheaper engineers enable
them to value engineer costs down and develop
indigenous machinery

Incentives and protection led to overcapacity and


sub-scale plants

zone

Macro factors

Country stability
Product market regulations

Import barriers

Preferential export access

Recent opening to FDI

++

Remaining FDI restriction

Government incentives

* Average annual FDI/sector value added


Source:McKinsey Global Institute

Import restrictions and high duties made it


important to set up assembly lines initially

O
O

FDI was allowed freely post 1993

+
O

In the absence of state govt. incentives (esp.


infrastructure promises), level of FDI likely to have
been lower

121

Exhibit 34

INDIA AUTO EXTERNAL FACTORS EFFECT


ON FDI
Impact on
level of FDI Comments

++ Highly positive

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

Impact
on per
$ impact Comments

Level of FDI*

Countryspecific
factors

Sector
initial
conditions

TRIMs

Corporate governance

Other

Capital deficiencies

Foreign partners required to bring substantial


amount of capital given inability of local players
unable to invest/raise sufficient funds

Labor market deficiencies

Archaic labor laws and unions worried MNCs


given need to substitute labor with capital

Informality

Supplier base/
infrastructure

Existence of a fairly developed components


industry encouraged MNCs to enter & localize

Competitive intensity

+ (L)

Low competitive intensity in a high potential


market encouraged players to enter India

Gap to best practice

+ (H)

Domestic players were highly inefficient (~5% of


US in 1999-00) and MNC players were capable of
being far more productive

TRIMS forced cos to invest a minimum amount &


localize quickly thereby increasing the level of FDI
investments

Higher localization led to lower prices, which in turn


increased demand and improved utilization and
increased productivity

Cheap and good quality components have helped lower


costs (& prices) and can potentially improve Indias
export competitiveness (both for cars + comps.)

++(L)

Very positive impact for consumers as prices fell and it


has helped boost overall productivity although
profitability has reduced

+(H)

Higher productivity of new players vs. domestic players


helped drive overall productivity further

O
O
O

Source: McKinsey Global Institute

Exhibit 35

INDIA AUTO FDI IMPACT SUMMARY

[ ] Estimate

++ Highly positive

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

External Factor impact on


FDI impact on host country
Level of FDI relative to sector*

NA

Economic impact

Level of FDI
Level of FDI** relative to GDP
Global factors

Sector productivity

++

Sector output

++

Sector employment

Suppliers

++

Impact on
competitive intensity

++

Distributional impact
Countryspecific factors

Companies
FDI companies
Non-FDI companies

Employees
Level
Wages

0.05%

Global industry
discontinuity

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

+
O
O
O

O
+
O

Macro factors
Country stability

Product market regulations


Import barriers
Preferential export access
Recent opening to FDI
Remaining FDI restriction
Government incentives
TRIMs
Corporate governance
Other

+
O
O
O
+
+
O
O

+
O
+
O
O
O
O

Capital deficiency

Labor market deficiencies

Informality

Supplier base/
infrastructure

O
+

Consumers
Prices

Selection

++

Government
Taxes

Per $ impact
of FDI

++

* Average annual FDI/sector value added


** Average (sector FDI inflow/total GDP) in key era analyzed

Competitive intensity

+ (L)

++ (L)

Gap to best practice

+ (H)

+ (H)

Sector initial
conditions

Preface to the Consumer


Electronics Sector Cases
Each of our four country cases, Brazil, Mexico, China, and India, are large
developing economies that have carried out some form of policy liberalization
toward foreign investments in the consumer electronics sector during the past
10 years. All of them have a large domestic consumer electronics market with at
least $8 billion in sales that of China being roughly four times the size of the
others (Exhibit 1). Yet the market and policy environment for foreign investments
has been quite different in each of the four countries, ranging from a largely open
market environment by the end of our study period in China and Mexico to the
more protected policy environments of Brazil and India. This preface provides the
background information necessary for a full understanding of the comparative
cases.
BACKGROUND AND DEFINITIONS
FDI typology. FDI in consumer electronics spans the range of FDI typologies.
Mexico has, in the period under review, received almost purely efficiency-seeking
FDI, mostly for assembly operations of products targeting the U.S. market. Brazil
and India have high import tariffs, and in the case of Brazil, unique standards,
both of which have limited imports and led to tariff-jumping FDI. China's large
domestic market has attracted market-seeking FDI, while its low labor costs have
attracted efficiency-seeking FDI. Both motives explain the large FDI inflow to the
country.
Sector segmentation. Our segmentation of the sector includes a broad and
representative range of consumer electronics categories, with somewhat different
characteristics:
PCs and peripherals. This includes desktops, laptops, and all their
peripherals, such as optical and magnetic storage, monitors, and keyboards.
This sub-segment is the furthest along the process of value-chain
disaggregation. Widely adopted hardware and software standards have enabled
the creation of separate markets for most components and peripherals. Most
of the component markets in this sub-segment are characterized by rapid
technological change and high levels of global competitive intensity.
Mobile handsets. This includes wireless telephone handsets only. The
segment is characterized by very rapid technological change (including
technology transitions from analog to digital and 3G); standardization at the
regional level (e.g., GSM in Europe and PDC in Japan) and a low bulk-to-value
ratio.
White goods. This includes refrigerators, washing machines, dishwashers,
window air-conditioners, and other household appliances. These products tend
to be bulkier to transport and have fewer components and a slower rate of
technological innovation than most other consumer electronics products. In all
the countries studied, domestic companies were already present. As a result,
acquisitions have played a more important role in white goods than in the other
segments.
Brown goods.
This includes home audio and video equipment such as
televisions, DVD players, VCRs, home stereo systems, and portable audio

Exhibit 1

COMPARATIVE DATA FROM CONSUMER ELECTRONICS CASES 2001


Finished
goods exports
$ Billions

Domestic sales
$ Billions

41

China

FDI*
$ Billions

23**

25

Mexico

10

Brazil

India

00
~

Labor productivity
Index***

32

25

24

5.1

40

3.6

13

2.4

* 1996-2001
** Adjusted to exclude estimate of semiconductor FDI
*** Indexed to Korea = 100: Base measurement = RMB/worker/hour
Source: National statistics; McKinsey Global Institute

Exhibit 2

TAX EXEMPTIONS TO EXPORTERS IN SPECIAL ECONOMIC


ZONES/REGIMES
Percent
Mexico

China

34

33
24
15
0

Normal
income tax

High tech*

Tax on
income in
special
zones

Tax on
income
in the
coast
line

3.4

Normal
income
tax

3.3
2.4

2.1
1.5

0
Maquiladora
tax on
revenues**

Normal tax
on
revenues***

High tech

Tax on
Tax on
Tax on
revenues*** revenues*** revenues***

* For the first 2 years


** For maquiladoras (main exporter) considering the Safe Harbor scheme which taxes 34% on the higher of 6.5% of total assets or 6.9% of total costs,
and considering that total costs are 90% of revenues
*** Considering a 10% profit margin
Source: Interviews, literature search; McKinsey Global Institute

equipment. This sub-segment is the most varied among all those studied in
that it covers products with very different bulk-to-value ratios and rates of
technological change (e.g., standard low-end radios, DVD players, and largescreen TVs).
Role of product mix and activity mix in explaining productivity. In consumer
electronics, there are very large labor productivity differences between different
steps in the value chain for the same product (e.g., capital-intensive component
production compared to the more labor-intensive assembly operations)1. There
are also significant differences in labor productivity between different products
(e.g., white goods compared to mobile phones). These differences are usually
much larger than the differences observed across countries within the same step
of the value chain of a single product: for example, many contract manufacturers
locate identical, highly automated component production facilities in a number of
countries that have very similar levels of labor productivity performance overall. As
a result, the most important explanatory factor for average productivity differences
between countries is the product mix.
Special economic zones/fiscal regimes. Developing countries, such as Mexico
and China, have attempted to attract efficiency-seeking FDI in consumer
electronics by giving foreign direct investment a special status tied to exports. This
can be achieved either through a special fiscal regime (such as maquiladoras in
Mexico that provide input tariff and tax exemptions2) or the development of a
special production locations (such as the Chinese Special Economic Zones
SEZs) that provide better infrastructure and lower taxes than available elsewhere
within the country concerned (Exhibit 2). These interventions have segmented the
overall consumer electronics sector and created a non-level playing field between
export-oriented manufacturing and production for domestic market.
SOURCES
Data. For Brazil, Mexico, and China, productivity, output, and employment
estimates were based on government statistical sources, and price information
was derived from price indices from public and proprietary McKinsey price surveys.
For India, company-level financial information was analyzed and aggregated to
estimate value add; employment data was gathered from public sources and
telephone interviews. UN PCTAS trade statistics were used for trade whenever
possible, with supplemental and comparative information gathered from national
statistical sources. One difficulty faced in data analysis in consumer electronics is
that countries often define the sector and its subsegments differently. We have
taken every step possible to ensure the comparability of the data used and have
noted wherever applicable where the various data sets that have subtle
definitional differences.
1.

2.

The different steps in production also vary in relation to the role economies of scale play: they
can be very large in some capital-intensive components, while negligible in some assembly
operations, where home-based informal players can remain competitive in the market.
This is in the process of being phased out by NAFTA and is due to end in January 2004.

Exhibit 3

KEY DATA SOURCES AND INTERVIEWS FOR CONSUMER ELECTRONICS


CASES
Key data
sources

China

Mexico

India

China Electrical

INEGI
Secretaria de

Company financials ABINEE


Center for
SECEX
Monitoring the
Banco Central
Indian Economy
FIPE
RBI India
CAMEX
UN PCTAS
SUFRAMA
database
IBGE
MAIT
ELCINA
Newspaper reports

Industry yearbook

China Light Industry


yearbook
China statistical
annual
Company financials
Sino market
research
Gartner
IDC
EIU
China Foreign
Trade and
Economy yearbook
Interviews 8 company
interviews
4 analyst and
expert interviews

Economia

Bancomext
BN RCTAS
CIEMEX-WEFA
U.S. Trade
Online

6 company
interviews
5 analyst and
expert interviews

2 company

Brazil

8 company
interviews
interviews
2 expert interviews 3 expert
interviews
Leveraged
extensive interview
base for CII report

Interviews. An assessment of the impact of industry dynamics and external


factors on the sector was made based on interviews with company executives,
government officials, industry analysts, and industry associations (Exhibit 3).
These sources were also used to verify the impact that FDI has had on productivity
and to understand the various operational factors that it might have influenced.

Consumer Electronics
Sector Synthesis
The consumer electronics sector (along with that of IT/BPO) is furthest along in the
process of industry restructuring among those studied. The production process
among most sub-segments has been disaggregated so that individual parts can
be manufactured in different places and assembled as a final product in another
location (exhibits 1 and 2). Each of our sample of four large developing countries
Brazil, Mexico, China, and India has gone through some form of foreign
investment policy liberalization during the past 10 years; we found the impact on
the host countries to be either positive or very positive in every case. However,
these positive impacts have surfaced in very different ways according to each
country's unique market and policy environment.
Consumer electronics has annual worldwide sales of approximately
$560 billion across our four sub-segments. The very globalized nature of the
industry has led to production and sales being spread throughout the different
regions of the world and to a high degree of trade.
PCs and components are the largest sub-segments among our sample of
consumer electronics products, representing a third of the total market with
sales continuing to grow. White and brown goods together represent half of
the global market. Mobile phones, which have roughly $100 billion in
annual global sales, are the fastest growing segment (Exhibit 3).
The largest end-user markets for consumer electronics are Western Europe
and the U.S. Asia (ASEAN, Japan, China, and Korea) and the U.S. are the
leading exporters of both finished products and components. This illustrates
the very different patterns by which different regions and countries have
been integrated into the global consumer electronics market (exhibits 4-7).
Leading consumer electronics companies have a global reach and, with a
few exceptions, more globalized players tend to produce higher returns for
shareholders (exhibits 8 and 9). The rate of overseas expansion for
companies in the sector appears to be accelerating over time (Exhibit 10).
China and Mexico have largely liberalized their policies toward foreign
investment in the consumer electronics sector. Both of them have seen a
boom in foreign investment and this has had a very positive impact on the host
countries, though in different ways.
China has been the most successful country among those studied in growing
its consumer electronics industry. Both market-seeking and efficiencyseeking FDI has flowed into China. This has led to a very rapid growth of
output and productivity in the assembly of final products. Market-seeking
FDI sought to tap into the $40 billion domestic market that continues to
grow at double-digit rates; efficiency-seeking FDI took advantage of low labor
costs and the supply chain serving the domestic market. This rapid growth
has in turn attracted a broad range of components suppliers so that China
is now steadily expanding from assembly to cover the full supply chain of
parts, including semiconductors.
The role of multinational companies in this success has been critical, as a
source of both technology and of managerial skills in serving the domestic
market and, even more importantly, as providers of access to their global
brands and distribution networks. Chinese domestic companies have also
played a very important role by creating a highly competitive industry
dynamic that has driven rapid cost reductions and productivity

Exhibit 1

CONSUMER ELECTRONICS VALUE CHAIN IS VERY DISAGGREGATED


ACROSS COUNTRIES COMPARED TO AUTOS
Consumer electronics

Auto

China:
motherboards
keyboards,
spoolers,
monitors
Suppliers

U.S.: sales
and marketing

Korea
DRAM
Taiwan
design
Thailand:
hard drive
Malaysia:
MPU

OEM
Suppliers
Design/
OEM
Suppliers R&D

Mexico:
assembly

Highly disaggregated value chain

Suppliers
OEM
Design/R&D
Suppliers
OEM supply
specialization
Suppliers
OEM

OEMs and suppliers produce in end


markets with much less intermediate
goods trade/specialization

Source: McKinsey Global Institute

Exhibit 2

GLOBAL TRADE/SALES IS VERY HIGH IN CONSUMER ELECTRONICS,


INDICATING A HIGH DEGREE OF GLOBAL SPREAD OF PRODUCTION
Global trade/sales ratios in consumer electronics
Global sales
U.S. $ Billions

Auto

Consumer
electronics

Global trade
U.S. $ Billions

500

1,200

566

IT/BPO

Source: McKinsey Global Institute

Trade/sales ratio
Percent

42

115

650

3,000

32

Exhibit 3

THOUGH BROWN AND WHITE GOODS STILL REPRESENT HALF OF THE


GLOBAL CONSUMER ELECTRONICS MARKET, PCs AND HANDSETS DRIVE
GROWTH
Global consumer electronics market size and growth by sub-segment
$ Billions
544
520
518
515
90

566

CAGR
Percent

97

7.1

74

76

80

150

158

163

179

194

6.6

124

115

110

113

110

-3.1

170

166

168

162

165

1996

1997

1998

1999

2000

Mobile phones
PCs and
components

Brown goods

White goods

-0.7

Source: IDC; Euromonitor; China Light Industry Yearbook; McKinsey analysis

Exhibit 4

THE LARGEST CONSUMER ELECTRONICS DEMAND REGIONS ARE US,


W. EUROPE, JAPAN, AND CHINA*
Sales
Overall production

Percent of World:Total of sales, production, exports, imports

Exports (finished goods)


Imports (finished goods)
Russia

Eastern Europe
2

0
Korea
2

Western Europe
33
27
21

9
Japan
12 14 15
US

37
China

20

15

15

12

India
2
2

Mexico
2

ASEAN
25
0

0
12

2
South Africa
1
0 0
0

South America
3

Middle East
1
1
0

Brazil

3
3 0
* Trade is finished goods trade
Source: UN PCTAS database; McKinsey analysis

Australia, New
Zealand/Oceania
2
0
0
1

10

Exhibit 5

JAPAN, U.S. AND ASEAN ARE KEY FINISHED GOOD EXPORTERS,


THOUGH CHINA, MEXICO AND E. EUROPE ARE GROWING RAPIDLY
Global consumer electronics sector finished goods trade volume vs. growth
Percent
Exports

CAGR
%
19962001

Imports

CAGR 50
%
19962001 40

70
60

E.Europe

India

50

China

30
40

20

30
20

China

Mexico

M. East
Taiwan

South 10
America

Brazil

Korea

E.Europe
Japan

10

Japan

Australian/NZ

0
Australian/
0 Middle east 20
40
NZ
W.Europe*
-10

60

$ Volume
Billions

20

-10

Brazil

-20

Russia

India

40

60

80

100

ASEAN
$ Volume
Billions

Russia

-30

US
W.Europe*

S. America
0
ASEAN

US

-20

Mexico
Taiwan Korea

-30

* W.Europe figure excludes Intra-European (among EU-15, Switzerland, Norway & Turkey) trade
Source: UN PCTAS Database

Exhibit 6

U.S., JAPAN AND ASEAN DRIVE COMPONENT EXPORTS


Global consumer electronics sector components goods trade volume vs. growth
Percent
Exports
CAGR 40%
%
19962001
30%

Imports
CAGR 40%
%
1996- 35%
2001

Middle east
China

30%

E.Europe
Taiwan
Brazil
W.Europe

20%
Australia
Mexico
/NZ
Russia
10%

ASEAN

Japan

40

60

80

100

Korea
Middle
Taiwan
east
Brazil
Japan
India
South America

10%

India

$ Volume
Billions

US
ASEAN

Australian/NZ

0%
0
-5%

-30%

W.Europe

5%

-10%

-20%

20%
15%

0%
20

Mexico

25%

US

Korea
South America

China
E.Europe

20

Russia

40

60

80

$ Volume
Billions

-10%

* Taiwan figure a proxy based upon sum of exports received and imports sent to Thailand from other countries
Source: UN PCTAS Database

100

11

Exhibit 7

COUNTRIES ROLE IN GLOBAL CONSUMER ELECTRONICS PRODUCTION


AND CONSUMPTION CAN BE SEGMENTED INTO PATTERNS
Input trade

High

Finished goods

Technology
exporter
Japan
Korea

Technology
processor/trader
ASEAN
US

Technology
stand-alone

Technology
importer
China
Mexico
Brazil
E. Europe
Australia/NZ
W. Europe

Final goods
exporter/
processor
China
High ASEAN
Mexico
Korea

Exports

Finished goods
specialized
producer/trader
Japan
E. Europe

Exports

Low
Low

Stand-alone final
goods producer
Brazil

Final goods
importer
US
W. Europe
India
Australia/NZ

Low

Low

High

High

Imports

Imports

Source: McKinsey analysis

Exhibit 8

CONSUMER ELECTRONICS PLAYERS ARE HIGHLY GLOBALIZED


Domestic vs. foreign sales for key consumer electronics manufacturers*
$ Billions, percent
100% = 27.9

28.9

62.4

78.8

85.9

40

41

30.0

33.2

13.2

44

46

47

22.7

77.9

51

52

23.2

69.7

59

60

Domestic sales
International sales

31.2

55.2

70

70

50.2

17
24
33

80

83
76
67
60

59

56

54

53

49

48
41

40
30

30
20

Nokia

Philips

Sony

HP
IBM
Compaq

Motorola

Samsung

Electro- Alcatel Siemens


lux

* European players domestic market is considered W. Europe


Source: Bloomberg; Company financials

LG

Matsushita Dell

Toshiba

NEC

12

Exhibit 9

HIGHLY GLOBALIZED CONSUMER ELECTRONICS PLAYERS HAVE


DISPLAYED HIGHER RETURNS TO SHAREHOLDERS
International sales as a percentage of total vs. TRS-CAGR* for selected consumer electronics firms
Percent
TRS-CAGR*
Percent
70
60

Dell

50

Nokia

Level of globalization and


performance are somewhat
correlated but there may be
other causal factors driving
the trend
Generally companies that
have international sales
accounting for more than
40% of total sales have
shown the best performance
over time

40
30

Samsung
HP
Philips
Electrolux
IBM
Whirlpool
Siemens
Sony
Motorola
Sharp
Acer
Matsushita
Fujitsu Sanyo
Pioneer
Toshiba
NEC
Alcatel
NEC

20
10
0
-10
-20
0

20

40

60

80
100
Int'l sales as a percent
of total

* Total Return to Shareholders, over period Nov 1, 1990 till Nov 1, 2002
Source: Datastream; Bloomberg; Company financials; McKinsey analysis

Exhibit 10

GLOBALIZATION SEEMS TO BE GAINING SPEED OVER TIME


1910

1920

Plants opened in
Germany and UK
(1926)

1930

Plants opened in
U.S.(1931)

1940

1950

Production begins in
Australia (1936)

1960

1970

1980

1990

2000
onwards

Manufacturing
presence

Production begins in
Brazil (1950)

Electrolux
Home sales and
manufacturing begin in
Sweden and sales begin in
Germany, UK, and France

Subsidiary established
in HK to sell goods
in Asia
Formal sales
presence
Factory set up
in Ireland

Production facilities set


up in U.S. and UK

Builds 9 plants across


Asia

Sony
Products
shipped to
U.S.

Sales in
Europe
Production
begins in USA

Production in
Germany

Production in
Hungary

Offices set up in NY, HK,


and Zurich

Nokia
(mobile
phones)

Sales begin
in U.S.
Sales begin
in UK, Singapore

Sales
in Brazil
Sales
in Australia

Sales begin
in Malaysia
Sales begin
in China

Source: Company websites

Sales in Germany,
Hungary, Japan

Sales
in Mexico
Sales
in Thailand

13

improvements in the sector. As a result, the greatest beneficiaries from this


success story have been consumers, who have seen rapid technology
growth and price reductions, both in China as well as globally.
Mexico has also been rapidly integrated into the global consumer electronics
value chain since NAFTA was signed in 1994. It has received over $5 billion
in FDI in the consumer electronics sector since then. Most of this has
resulted from U.S. companies setting up assembly operations for final goods
in Mexico destined for the U.S. market. Foreign investment in the sector
has had a very positive impact on Mexico as a whole, creating over 350,000
jobs and $14 billion in net exports. However, the spillover effects from this
investment in assembly operations have been limited, as most components
are sourced from the U.S. or Asia (exhibits 11 and 12).
Mexico's role in global consumer electronics hinges on its closeness to one
of the largest end-user markets, the U.S. It had neither the large domestic
market nor the low labor costs of China, nor does it benefit from other cost
advantages seen in China (exhibits 13-16). In order for it to continue to
maintain its strong position as an assembly location, Mexico will need to
continue to improve productivity and focus on products that can gain real
benefits from Mexico's proximity to the U.S. These benefits could consist of
reduced transportation cost or time, or result from ease of interaction with
the end users (exhibits 17-24).
Brazil and India are different in that, while they have opened up their domestic
markets to foreign investment, they have nevertheless maintained a highly
regulated environment. In both these cases, international companies have set
up operations in Brazil and India in order to overcome these policy barriers and
to be able to participate in the domestic market.
FDI has had a positive impact in both countries, largely as a result of the
increased competition that international companies have brought to the
domestic market. This has led to lower prices and higher sales to domestic
consumers. However, the remaining policy barriers (e.g., high domestic sales
taxes) have kept prices of domestic production above world prices and have
consequently reduced the competitiveness of Brazilian and Indian products for
export.
Brazil opened up its consumer electronics sector by repealing information
laws that had prohibited foreign companies from entering the domestic PC
market. However, tariffs of up to 30 percent on final goods and Brazil's
unique standards (such as the PAL-M TV standard) limited imports. As a
result, many international players have entered Brazil, either through
acquisitions or through greenfield investment. This investment has led to
productivity improvements and rapid growth in output and has since created
a successful export industry in mobile handsets (Exhibit 25). While
increased competition has benefited consumers through declining price
premiums above global market prices, very high tax rates and high
production costs continue to keep Brazilian prices well above international
levels. Production costs are high as a result of the investment made in highcost locations, such as Manaus. These high costs might well erode the
competitiveness of Brazil's export production over time (exhibits 26 and 27).
India allowed foreign companies to enter the domestic market for the first

14

Exhibit 11

MEXICO IMPORTS MOST INPUTS FROM THE U.S. AND ASIA


Share of total inputs

Korea

40%

Japan

Shanghai
Shenzhen

60%

Because Mexico imports most of its


Taiwan

U.S.

65%

15%

inputs from Asia and the U.S., its


component logistics are 30% more
expensive (i.e., shipping components
from Asia is costly and the U.S.
components are expensive)
Mexicos main component imports are
electronic microcircuits and PCBs

China, Taiwan,
Korea, Japan,
Malaysia
20%
Source: Interviews

Exhibit 12

FOR MEXICO, TUBE GLASS MUST BE SOURCED FROM THE U.S., ADDING
SIGNIFICANTLY TO TOTAL COST PRODUCTION*
Difference between China and Mexico Glass prices
Percent

Tube glass
manufacturers

100

10

120

Glass
cost
China

Higher
U.S.
labor
costs

Energy
and land
and
other
components

Higher
taxes**

* NAFTA rules stipulate that TVs imported from Mexico to US with non-NAFTA tubes must pay 15% import tariff
**Considering a 34% tax in the U.S. and 15% tax in China
Source: McKinsey analysis; US and China tariff schedule

Glass
cost
Mexico

15

Exhibit 13

CHINAS ADVANTAGES OVER MEXICO ARE IN INPUT COSTS, FACTOR


COSTS AND TAXES Advantage
Description
China has a more developed supply chain across all electronic
industries

Unit manufacturing costs

Input Costs

Sources of cost advantage in inputs are logistics and factor costs


Mexico loses competitiveness on items it must import from the
U.S. (e.g., TV glass)

Productivity at very similar levels per both estimates and expert


interviews

Productivity

China offers distinct cost advantages in labor (skilled and

Factor costs

unskilled), electricity and land costs

Mexicos geographic proximity to the U.S. as well as similar time


zone lowers interaction costs with the U.S.

Interaction costs

This is especially important for newer and customized products

Other costs

Border zones provide shipping advantages


However, the geographical location advantage is far from being
maximized

Transport costs

Furthermore, component logistics increase costs for Mexico

Tariffs

Mexico has tariff advantage (e.g., TVs) or parity (e.g., computers)

=>

with China

Income taxes on manufacturing is much lower in China than in

Taxes

Mexico

Exhibit 14

OVERALL, FACTOR COSTS ARE ACROSS THE BOARD HIGHER IN


MEXICO THAN IN CHINA
Factor cost comparison Mexico
Unskilled

Land

Energy

$ per hour

$/Sq.M manufacturing land


rent

US cents/Kwh ind. electricity

China

0.59

China

India

0.65

Malaysia

37.44

Mexico

1.47

Taiwan

37.68

Brazil

1.58

Mexico*
India

Malaysia
Taiwan
Korea
U.S.

1.73
5.39

U.S.

6.44

Brazil
21.33

Korea

China

33.00

U.S.

3.76
4.98

Mexico

5.40

42.00

Korea

5.55

43.04

Taiwan

5.60

Malaysia

5.63

48.48
78.00
94.53

Brazil
India

6.07
9.28

Mexicos factor costs are


more expensive than
Chinas across the board

* Average land cost in Ciudad Juarez, Chihuahua


Source: Literature searches, EIU, ICBC, Monthly Bulletin of Earnings and Productivity Statistics (China); Taipower, WEFA WMM, DRI WEFA,
Healy & Baker, ILO, Malaysian Ministry of Human Resources, Central Bank of Malaysia, State Economic Development Corporations
(Malaysia), Malaysian Industrial Estates Bhd., Malaysian Statistics of Electrical Supply, Tenaga Nasional (Malaysia), Folha de SP
(Brazil), Aneel (Brazil), Bancomext (Mexico), Expansion (Mexico)

16

Exhibit 15

CHINA HOLDS A 10 POINT LANDED COST ADVANTAGE IN TVs


TO THE U.S.
Breakdown of sources of cost advantage for China in TVs
Indexed numbers, China=100

Mexicos advantages over China


are distribution and tariffs which
are not enough to compensate
Chinas advantages

ESTIMATE

5-10

108-113

13
100

China

Tax*

Labor

Energy +
land

Margin

Component
transportation

Tariff

Transportation of final
product

Mexico

*Considering a 34% income tax in Mexico and a 15% tax in China


Source: Interviews; McKinsey analysis

Exhibit 16

CHINA ALSO HOLDS A 9 POINT LANDED COST ADVANTAGE IN


DESKTOP PCs TO THE U.S., THOUGH OBSOLESCENCE COST
COUNTERACTS THIS
Mexicos
Breakdown of sources of cost advantage for China in Desktop PCs
Indexed numbers, China=100

100

China

109
3

Income
tax*

-1

Transportation**

Labor

Component
logistics

Mexico

ESTIMATE

advantage over
China is
transportation
which is not
enough to
compensate
Chinas other cost
advantages
Additional
advantage for
products with short
lifecycles like PCs
(obsolescence
concerns)

*Considering a 34% income tax in Mexico and a 0% tax in China


**Does not consider inventory costs for China; it considers transportation costs for Mexico from Guadalajara to Laredo
Source: Interviews; McKinsey analysis

17

Exhibit 17

SEVERAL KEY INDUSTRIES FOR MEXICO ARE THREATENED BY CHINA


Summary of Mexicos and Chinas share of U.S. Imports, 2002

Industry
1. 20- 30 TVs
2. Laptops

Threatened
industries

Mexicos share
change 1998-2002
%

-22
-16

77
9.4

3. Refrigerators

-14

0.4

4. Converters & decoders

-12

5. Satellite RX for TVs

-10

1.3
0.7

-8

0.7

7. Stoves

-6

0.5

8. Cellular phones

-2

9. Projection TVs

-2
53
36
27

91

15

0
30

49

13
72

18

1.8

7. Control units

14

70

0.9

6. Car CD players

13

45

3.4
1.9

10

98

1.5

20

9. Monitors

5
0

15

1.4

4. Car tape players


5. Digital switches

8. Display units

12
5

83
10.4

45

53
74

1.7

2. Laser printers
3. Digital Processing Units

10
6

13
85

6. 30 TVs

10. Parts for PCs

China
%

1.4

1. TV set top boxes

Growth
industries

Total U.S. Imports


Billion USD
Mexico
%

55

41

4.4

16

4.1

14

3.0

17
10
30

30
7.7

39

28

Source: US Trade online, McKinsey analysis

Exhibit 18

MEXICOS CONSUMER ELECTRONICS EXPORTS TO THE U.S. HAD BEEN


GROWING UNTIL 2001
Billion USD
80
70
60
50

Japan

40
China

30

Mexico
Malaysia
Taiwan
Korea
Germany

20
10
0
1999

France

2000

Note: Imports include brown goods, PCs, white goods, and telecom products
Source: US Trade online, McKinsey analysis

2001

2002

18

Exhibit 19

CHINA HAS RECENTLY THREATENED THE VITAL 20-30 TV SEGMENT


U.S. Television Imports from China and Mexico, 2001-2002
Thousand televisions
Size

2001

2002

10

466

290

14

155

80
3,640

18-20

Mexico

20-30

2,060
10,790

10,400

1,129

Projector

1,400
16,180

Total
10

372

14

192

14,230
670
52

29

18-20

China

Contested market

~2,800%
growth in
one year

43
3,300

112

20-30
Projector

21

15
4,080

726

Total
Source: US Trade online, McKinsey analysis

Exhibit 20

CHINA AND MEXICO ARE NEARLY EQUAL IN LABOR PRODUCTIVITY


Consumer electronics Labor productivity**
2000; Index*, Korea = 100

Mobile handset assembly**


100
52

n/a

n/a
In
di
a

C
h
in
a

n/a
M
ex
ic
o

B
ra
zi
l

M
al
ay
si
a

K
or
e
a

n/a

PCs and components assembly


Labor productivity (excl. mobile phones)
Value add/FTE
100
25

24

C
h
in
a

28

24

11
In
di
a

M
ex
ic
o

B
ra
zi
l

38

29

M
al
ay
si
a

34

K
or
e
a

40

100

13

In
di
a

55

C
h
in
a

34

35

In
di
a

61

M
ex
ic
o

B
ra
zi
l

K
or
e
a

47

M
al
ay
si
a

na

ex
ic

100

Ch
i

al
ay
sia
M

Br
az
i

Ko
re
a

Brown goods assembly

White Goods
100

C
h
in
a

19

17

12
In
di
a

34

M
ex
ic
o

B
ra
zi
l

M
al
ay
si
a

K
or
e
a

35

* Indexed to Korea = 100: Base measurement = RMB/worker/hour


** Koreas mobile handset industry definitions includes other wireless devices such as wireless broadcast transmitters and wireless closed
circuit cameras; Indias numbers are calculated using data of listed companies (largest); they may be biased upward because of this
Source: China: China Electrical Industry Yearbook, China Light Industry Yearbook; Korea: National Statistical Office, Electrical Industry
Association of Korea; Malaysia: Annual Survey of Manufacturing Industries, Department of Statistics; Brazil: IBGE, FIPE; McKinsey
Global Institute

19

Exhibit 21

HOWEVER, AT THE CURRENT GROWTH RATE, CHINESE BROWN GOODS


China
PRODUCTIVITY WILL REACH MEXICOS IN 3-4 YEARS

Mexico

Productivity annual growth rate


Percent
39

30

19
14

White good

Brown goods

Source: INEGI; China Electrical Industry yearbook, China Light Industry yearbook, China Statistical Yearbook

Exhibit 22

IN THE SHORT-TERM, MEXICO MUST FOCUS WHERE IT HAS NATURAL


ADVANTAGES
Products that favor Mexico

Products that favor China

White goods
Medium/large television

Laptop computers

sets
Telephone switches

Portable radios
Mobile phones

Car CD and tape players

N/A

Desktop computers
Laptops
Cellular phones

White and brown goods

Telephone switches
Industrial electronics

CTVs

Rationale

Interaction Sensitive

Transport Cost Time


Sensitive

Goods that have low value/weight ratio


Low value/ weight,
volume

are relatively more expensive to ship

Mexicos auto industry has sustainable


Auto
electronics

Short
obsolescence
cycle

High
customization/
early lifecycle

geographic advantage, they benefit


from having integrated electronics
supply

Shipping via sea takes 6 weeks for


China vs. just days for Mexico; short
obsolescence cycle items lose their
value to quickly

Due to proximity to US frequent


interaction needed for early life-cycle
goods will be easier

Because of long lead time from China,


High demand
volatility

(air shipment)

high demand volatility items will be


difficult to manage
Mexicos underdeveloped supplier
industries may neglect some of this
advantage

Desktop computers
Laptops
Cellular phones

20

Exhibit 23

AND CAN FIND OPPORTUNITIES WHERE PRODUCTION STILL TAKES


PLACE IN THE U.S.
(n) % of total Mexican
Evolution of imports in the U.S. market, 1997-2001
Billion USD

CE exports to the
U.S., 2002
Mexicos
opportunities

100%
Phones (6)
Monitors (4)
Mature import
market

Audio for cars


(6)

Imports share of
domestic market, 2001

Laser printers
(3)

Leveling
import market

TVs (16)

Peripherals
(3)

Product
lifecycle

Computers
(13)

Local
production
market

Refrigerators
(2)

Emerging
opportunities

Switches (4)
-100%

100%

0%
Imports growth, 1997-2001

Source: US Census Bureau; McKinsey analysis

Exhibit 24

ANECDOTAL EVIDENCE FROM SOME KEY PLAYERS SHOWS A CHANGE


IN THE PRODUCT MIX TO HIGHER VALUE ADDED PRODUCTS
Subsector

Player

Type

Jabil

Contract PCBs for control panels, Car electronics (new


manufacturer

PCs

TV industry OEMs
in general

Traditional products
energy consumption
devices, PCs

Color TV with cathode


ray tubes

New products
plant in Chihuahua)

Plasma and LCD


technology TVs

Car audio (CD players,


speakers)

Brown goods

LG

OEM

TVs, DVDs, CDs

Refrigerators (new
plant in Monterrey)

GE Mabe

OEMs

Refrigerators and
ranges

White goods

Across
Whirlpool

Siemens
Telecom

OEM

Telephones, electrical
equipment, medical
equipment

Source: Interviews; Expansin; Veritas; McKinsey analysis

Refrigerators (new
plant in Celaya and
Vitro acquisition
respectively)

Refrigerators (new
plant in Queretaro)

Companies based in
Mexico have to
maximize their
advantages to stop
losing
competitiveness
In order to maximize
Mexicos main
advantage
(geographic
location),
companies have to:
Migrate to
transportation and
interaction cost
sensitive products
And/or improve
their process
design skills that
increase flexibility
and therefore the
ability of
producing early
lifecycle products

21

Exhibit 25

BRAZILS EXPORTS IN CONSUMER ELECTRONICS ARE DRIVEN BY


GOODS THAT CAN BE AIR SHIPPED LIKE MOBILE HANDSETS

USA
Mexico

Export evolution

Exports
by country year 2000 to 2002

US$ Million

Others

Venezuela
Argentina

1,072

6
9

7
849

718

10
3

52

74

85

191
113

32

1998 1999 2000 2001 2002

2000

2001

2002

Source: Abinee

Exhibit 26

HIGH TAX LOADS IN BRAZIL SUPPRESS LOCAL DEMAND


Breakdown of price of refrigerator in Brazil
Percent

EXAMPLE

4.2
18.0
9.2
0.4
1.0

Almost half of

5.3

the consumer
price are taxes

9.9
100.0

10.4

Some taxes are


added up in all
step of the
chain, as CPMF
and PIS/Cofins

41.6

Product
cost

Manufacturer Import
margin
tax

Labor
tax*

CPMF
tax*

PIS/
Cofins
tax*

Taxes represent
43.8% of consumer
price

* Consider taxes paid by both manufacturer and retailer


Source: Interviews; McKinsey analysis

IPI tax

VAT tax

Retailer
margin

Consumer
price

22

Exhibit 27

BRAZILS MANAUS FREE ZONE HAS MANY TAX ADVANTAGES, BUT


MAKES EXPORT COMPETITIVENESS DIFFICULT FOR SOME GOODS
Cost advantage*

Location

Additional costs

Percent
Manaus

Belm

100
15
6

So Paulo
80

Manaus is located in the middle of the

Cost
So
Paulo

IPI
tax
(15%)

VAT Inventory Import Freight*** Cost


margin
cost **
tax + IPI
of imported
items

Amazon forest, ~ 2,500 miles from So


Paulo, a main consumer market
Trucks proceed to Belm by river
(5 days) then by road, taking
10-20 days to get to So Paulo
Freight cost between 3% and 7% for
consumer electronics products (except
white goods)

* Assuming a non-white CE product with 25% of cost as imported components and 20% margin. Labor cost differences not
assumed
** Assume 2 month component stock and 18 days delivery to south-east
*** Assume only extra freight cost compared to So Paulo
Source: Interviews; McKinsey analysis

23

time in the early 1990s, but it continues to protect domestic production


through tariffs of 30-40 percent on imports. The growth potential of India's
domestic market has attracted many international companies to make direct
investment. This has both increased the level of competition and helped to
reduce consumer prices. However, the many remaining policy barriers
such as high indirect taxes, high and poorly enforced sales taxes resulting in
informality, and distorting state-level tax incentives leading to fragmented
and sub-scale production keep domestic production prices well above
world prices (exhibits 28-30). As a result, Indian consumers continue to
face 30 percent higher prices than Chinese consumers. The level of
penetration for a range of goods, such as refrigerators or mobile phones, is
significantly below Chinese levels (exhibits 31-35).

24

Exhibit 28

HIGH INDIRECT TAXES CONTRIBUTE STRONGLY TO HIGHER PRICES IN


INDIA
Indirect Taxes in India
Percent
Mobile*
phones

Retail prices
USD per unit

India
China

816
604

24
349

357

291

240

270
180

24

PCs

33

Refrigerators

TVs

Difference
Percent

24

Mobile phones
~17

PCs
26

Refrigerators
33

TVs
33

Mobile phone grey market


Percent
90

China
Percent

50

Most goods

14

Sales tax

Maharashtra
9*

Punjab
4

* Includes 4% sales tax and 5% octroi


Source: National statistics; literature search; McKinsey Global Institute

Exhibit 29
India

INDIAS TARIFFS ON INPUTS ADD TO FINAL PRODUCT

China

Import duty on
raw material
Percent
30

CPT

60

1,010

30

805

10

37

15

Aluminum

33
25

Price
difference
Percent

42

10

Plastic

Capital
equipment

Price
Dollar per unit or ton

N/A

Increase in final
good cost
Percent

30

+10% to TV
cost

21

+1% to TV cost
+ 3% to
refrigerators

11

+3% to TV
refrigerators

25

+2% for assembly


+4% for capital
intensive inputs

* Note that this price difference is for a commodity Intel motherboard that is probably manufactured in India; if
these parts were imported, the price would be much higher and impact on final goods price much stronger
Source: McKinsey CII report; McKinsey Global Institute

25

Exhibit 30

SALES TAX EXEMPTIONS DRIVE MANUFACTURING FRAGMENTATION IN


INDIA
Production per location
Thousand units

LG Manufacturing facilities in India

Contract
CTV
assembly

Mohali

Owned CTV
assembly

Noida

LG India

Guwahati

Lucknow

220

Kolkata

Surat

Contract
CTV
assembly

Average
China*

Chennai

Sales tax exemptions


for local manufacturers
drives fragmentation
Though electronics
manufacturing is not
strongly scale sensitive,
fragmentation certainly
reduces productivity
due to increased
1,000 overhead, capital
investment, and
complexity

New CTV
plant
* Average for three large producers that make between 600,000 and 1.7 million TVs per plant
Source: Literature search; McKinsey Global Institute

Exhibit 31

CONSUMER ELECTRONICS PENETRATION RATE IS MUCH HIGHER IN


CHINA THAN IN INDIA

India

Percent of total population

China

45
40
32
24

14

13

Mobile
handsets

0
<1

TVs*

* Color
Source: Literature searches; Euromonitor

PCs

Refrigerators Window unit


air conditioners

26

Exhibit 32

RETAIL PRICES FOR MANY CONSUMER ELECTRONICS GOODS ARE


SIGNIFICANTLY LESS EXPENSIVE IN CHINA THAN IN INDIA
U.S. Dollars, 2002

India
China

2,670
2,443

1,578

349

291

Mobile
phones

270

357
188

180

TVs

White
goods
exhibit the
largest price
differences

240

Dishwashers Refrigerators Laptops

Source: Euromonitor; National Statistics; literature search; McKinsey Global Institute

Exhibit 33

DOMESTIC MARKET SIZE COMPARISON

India
China

Annual domestic
consumptions, 2000

Product

Unit

Steel

Million tonnes

Aluminum

1,000 tonnes

PVC

1,000 tonnes

Beer

Million litres

CTVs

Million units

5
30

6.0

Air-conditioners Million units

0.6
12

20.0

Motorcycles

Million units

3.7
12

3.1

Cement

Million tonnes

Cigarettes

Billion units

Ratio

28
141

5.0

550
3,530
930
3,150
550
22,310

100

6.4
3.4
41.0

5.8

580
82
1,750

Source: China Statistical Yearbook; Industry Associations; interviews; press articles; CMIE

21.3

Higher consumption
cannot be
explained
by higher
income
alone

27

Exhibit 34

DRIVERS OF DIFFERENCE IN DOMESTIC CONSUMPTION IN COLOR TVs


Million units, 2000
Consistent with price elasticity of 3;
volume double at 30% lower prices

30

16

14

9
5

India

Difference due*
to differences in
population and
income

Expected consumption in
China at
Indian prices

Difference due
to lower prices
in China

China

* Additional consumption in China assuming same levels of penetration across Chinas income categories as in India
Source: McKinsey analysis; CETMA

Exhibit 35

DRIVERS OF OVERALL PRICE DIFFERENCES


Indian retail price indexed to 100

100

14-16
3-4

India
retail
price

Indirect Cost of
taxes
capital

Excise
Sales
tax

2-3

0-2

Capital Labor
produc- costs
tivity

2-5

4-6

0-1

67-72

Labor
Manuf- Retailing Chinese
product- acturing margins retail
ivity
margins
price

Capacity
utilization

Scale

Source: Plant and store visits; discussions; data analysis; McKinsey analysis

28

Brazil Consumer
Electronics Summary
EXECUTIVE SUMMARY
Until the early 1990s, information laws that prohibited foreign players from
entering the Brazilian PC market and high tariffs protected the approximately
US$9 billion domestic Brazilian consumer electronics market. The Brazilian
government attracted FDI in the early 1990s by repealing the information laws
and providing significant tax incentives for companies to produce goods in
Manaus. Nevertheless, high import tariffs (of 30 percent on finished goods)
continued to be imposed. These tariffs, combined with unique Brazilian standards
for certain products (such as the PAL-M standard for color TVs) continued to make
it difficult for foreign companies to export to the Brazilian market. In order to
overcome these barriers and capture market share, international companies set
up production facilities in Brazil following the liberalization. As a result, FDI in Brazil
has been mainly tariff-jumping market-seeking. International companies have
entered Brazil mostly through acquisitions and greenfield investments; Manaus
represents approximately 30 percent of all consumer electronics employment in
Brazil.
Overall, the entry of FDI companies has had a positive impact in Brazil, increasing
the level of competition and fostering operational improvements that have led to
an annual productivity growth of six percent in white goods and four percent in
brown goods. This has driven down retail prices for consumers who have benefited
from increased purchasing power. Brazil has also succeeded in creating a rapidly
growing mobile handset market, with 85 percent of total exports in 2002
(~US $911 million) sold to the U.S.
The impact from FDI could potentially have been even stronger. While increased
competition has benefited consumers through declining prices, the very high
remaining tax rates and high production costs, particularly in Manaus, continued
to keep prices 16-36 percent above world retail price levels as a result of Brazil
specific standards, heavy taxes, and high import tariffs. These factors may erode
Brazil's competitiveness of production for exports.
SECTOR OVERVIEW
Sector overview
Domestic consumer electronics production has fluctuated between
US $9-11 billion in the late 1990s and early 2000s; this is nearly equal to
total domestic sales as net finished goods exports are less than
$500 million annually (Exhibit 1). Macroeconomic instability (e.g., the
recessed market and unemployment), high interest rates, and the onset of
an energy shortage in Sao Paulo have caused the growth in domestic sales
to flatten/drop off.
Sales growth has been strong in mobile handsets, PCs, and white goods,
all averaging over 17 percent CAGR 1998-2001.
Brazil is not a large exporter of consumer electronics, with only
$1.5 billion in finished goods exports in 2001. That said, its consumer
electronics exports have been growing robustly since 1996, driven mainly

29

30

Exhibit 1

BRAZIL CONSUMER ELECTRONICS MARKET GROWTH BY SUBSEGMENT


Real R$ Billion as of 2002
CAGR
%
25.5

25.1

18

5.3

4.3

32

8.0

8.7

26

7.6

7.2

4.6

4.6

4.9

17

1998

1999

2000

2001***

10.4

8.4

11.1

20.0
15.1
Mobile handsets

1.9

PCs

4.3

Brown goods*

5.9

White goods**

3.0

US$ Billions

4.1
5.8

5.5

9.3

* Include electric and electronic finished products made in Manaus adjusted for total market
** Include only refrigerators, freezers, stoves and microwave ovens
*** Reflects impact of energy shortages
Source: IDC; Dataquest July 1999; Eletros; Suframa; McKinsey Global Institute

31

by growth in mobile handset exports (exhibits 2 and 3).


Brazil is a large net importer in consumer electronics, due to its reliance
on foreign sources of supply for key inputs (e.g., semiconductors).
Overall, Brazil's consumer electronics trade balance stood at -$3.5 billion
in 2001 (exhibits 4 and 5).
FDI Overview
FDI characteristics
FDI in the sector has fluctuated a great deal between 1996 and 2001,
from less than $100 million in 1996 to nearly $1.2 billion in 2001.
Overall, consumer electronics is a small recipient of FDI in Brazil,
averaging only 3 percent of Brazil's total FDI over period under review
(Exhibit 6).
FDI companies have entered both through acquisitions and greenfield
entry, as well as a small number of joint ventures. The number of
international companies entering the market increased substantially in
the late 1990s, encouraged by the stabilization of the currency and
increasing market liberalization (exhibits 7-9).
FDI impact quantification. Due to the limited availability of data we cannot
make comparisons of the pre-FDI period (pre-1994) with the maturing FDI
period (1994-present); furthermore, the fact that macroeconomicstabilization and FDI entry were happening simultaneously further
complicates this comparison. We have therefore assessed the impact of FDI
using qualitative information from interviews or comparisons with other
countries.
External factors driving the level of FDI. The factors most important in
attracting FDI to Brazil were: the country's macroeconomic stabilization of the
mid-1990s, its large market potential, the continuance of import barriers
(which made it impossible to participate in the local market without local
operations), and the liberalization of FDI-entry in the early 1990s (particularly
in the PC sector). However, Brazil's infrastructure particularly its dispersed
production footprint between Manaus and Southern Brazil (which was
encouraged by tax policy) hindering the attractiveness of efficiency-seeking
FDI, especially in brown goods.
Factors that have encouraged FDI
Sector market size potential. Given its population of nearly 170 million
and the lure of a potentially growing middle class (post stabilization),
Brazil represents a large and developing market.
Import barriers. Though import barriers have decreased steadily since
1995, tariffs are still high for consumer electronics goods generally,
slightly over 20 percent. Furthermore, Brazil unique standards (such as
Pal-M TV standard) encourage Brazil-specific manufacturing capacity.
However, the import barriers, combined with the market size potential,
have encouraged FDI in Brazil.
Country stability. The implementation of Plano Real and the subsequent
currency stability was followed by heightened interest in the Brazil
consumer electronics market. This is accentuated by the fact that most
consumer electronics purchases in Brazil are financed, which means
stabilization and market growth are highly interrelated. As a result,
almost all the FDI occurred post Plano Real.

32

Exhibit 2

TRADE IN BRAZIL CONSUMER ELECTRONICS SECTOR


US$ Million, 2001
Consumer Electronics Exports
CAGR: 42%

Total Brazil trade, 2000 =


US$ 113.8 billion
%

Consumer
electronics

266

356

1996

1997

737

865

1998

1999

1,465

1,530

2000

2001

Consumer Electronics Imports*


CAGR: 4%
777

859

1996

1997

1,091

1998

943

831

944

1999

2000

2001

* Only finished products, not included components


Source: Abinee/Secex (Alice); Central Bank

Exhibit 3

MOBILE HANDSETS ARE PUSHING EXPORT VOLUME


Export evolution US$ Million
USA

Exports
by country year 2000 to 2002

Mexico

Export evolution
US$ Million

Others

Venezuela
Argentina

1,072

7
849

6
9
7

718

10
3

52

74

85

191
113

1998 1999 2000 2001 2002

Source: Abinee

32

2000

2001

2002

33

Exhibit 4

ANALYSIS OF NET TRADE IN BRAZILIAN CONSUMER ELECTRONICS


SECTOR, 2000
Finished goods
US$ Million
1,468

Overall
Overall consumer
consumer electronics
electronics
963

1,969
1,969

505

Exports

Imports

Net exports

Inputs

-3,530
-3,530

US$ Million

Largest imports include:


Electronic microcircuits
TV/telecom parts

38%
24%

Exports
Exports

Net
Net exports
exports

Imports
Imports

501

Consumer
electronics
trade deficit *
of ~47%
-4,035

Exports

Imports

Net exports

* Trade deficit overstated as some input imports are used in non-consumer electronics (e.g., medical electronics)
Note: UN PCTAS data is used here for comparability with other countries
Source: Secex; UN PCTAS database; McKinsey Global Institute

Exhibit 5

IMPORTS FROM ASIA ARE INCREASING


Global Brazilian imports by electronics input origin and type, %
Origin of input imports*

CAGR

Type of input imports, 2000**


Total (US$ Billion) = $ 4.5

Total (US$ Billion) = 2.8


China
0,1
Japan

0.4

South Korea

0.2

Taiwan

U.S.

0.1

3.2

4.5

6%

0,1

0,2

19%

0.4

0.7

0.4

0.5

0.1

0.3

5%
2%
8%

1.0
1.2

1.7

Others*
Oth.electronic
9%
valv,tubes
9%
Batteries,

Electronic
microcircuits
38%

accumulators 4%
Diodes,
6%
transistors etc.

19%
21%

TV, Telecom
Equipment
Rest of World

3%
5%
TV picture
tubes,CRT,etc

Electrical Printed
capacitors circuits

1.1

1998

5%

1.0

1.3

1999

2000

6%

* Input imports include other input imports besides brown goods, PCs, white goods, and telecom products
** Others include all the electronic inputs with percent share less than 5 percent
Source: UN PCTAS database

34

Exhibit 6

PLEDGED FDI IN BRAZIL CONSUMER ELECTRONICS SECTOR*


U.S. $ Million

1,197

1,151

Most of the
investment is
concentrated in
the sector of PC
and office
equipment
manufacturing,
as well as
related
components

678

312
206
72

% of total
FDI to Brazil

1996

1997

1998

1999

2000

2001

0.9

1.3

1.3

4.2

2.3

5.7

* Includes 2 main sectors: Manufacturing of office equipment, PCs and related components; Manufacturing of
electronic and communication equipment; white goods are not included
Source: Brazilian Central Bank

Exhibit 7

TIMELINE OF FDI ENTRY


NOT EXHAUSTIVE
Market development
(1950 to 1975)

Market closure
(1975-1992)

Market liberalization
(1992-1997)

Market adjustment
(1998- )

Brown and
white goods
Philips (1948)

Panasonic (1967)

Whirlpool (1994)
Acquires Multibrs

Sony 1972)

Bosch (1994)
Acquires Continental

Toshiba (1977)

LG (1996)
Electrolux (1996)
Acquires Prosdcimo

GE (1997)
Acquires Dako

SEB (1997)
Acquires Arno

Taurus (2002)
Acquires Mallory

PCs
IBM (1917)

Mobile
handsets

Source: Literature search; company websites

Compaq (1994)

Dell (1999)

Motorola (1995)
Nokia (1996)
Ericsson (1997)
Samsung (1999)

Most of the
investment
was made
after
currency
stabilization
in 1994

35

Exhibit 8

CONSUMER ELECTRONICS MARKET SHARE BY SEGMENT BRAZIL


FDI player

Percent
Mobile handsets
Others
2001
Gradiente
7
5
Samsung
7

PCs 2001*
Compaq

13
Nokia

36

LG 8

Ericsson

Metron

9
Others 49

8 IBM
7

18

Itautec Philco

7
3 4
Dell
Novadata HP

18
Motorola

* Does not include grey market (60% of sales)


TVs 2001

Refrigerators 2000
Others

Semp
Toshiba

10

Panasonic

CCE

21

Others

BS Continental

7 1
10

CCE 10

Multibrs
53 (Whirlpool)

20
13
Itautec
Philco

Philips

Electrolux

29

17
LG

Source: Communications Top 100; Computerworld; Datamark; Philco

Exhibit 9

EVOLUTION OF THE BRAZILIAN CONSUMER ELECTRONICS SECTOR


1950-2001
Market development
(1950 to 1975)
External
policy

Internal
market

Market closure
(1975-1992)

Incentive through market

Foreign companies

closure by government
Strong FDI
Focus in local market

forbidden to participate in
the market (only with
local players)
Imports prohibited
Only local companies can
import foreign products
(IT), forcing transfer of
technology
Tax incentives to
manufacture in Manaus

Entrance of foreign

Concentration of

players building plants


among them Sony,
Panasonic, HP
Local companies still
dominate the market
Production mainly
focused in TV and radio
equipment, as well as
small electrical
appliances
Performance Strong market
development

production in Manaus,
both finished products as
well as components
Low level of FDI
Initial production of PCs

n/a

Source: www.maquilaportal.com; interviews; McKinsey Global Institute

Market liberalization
(1992-1997)

Importation allowed
Low import taxes until
mid 90's

FDI allowed

Increase in competition
Entrance of standalone
foreign players as well as
acquisitions of locals
Beginning of production
of mobile handsets
Closing of several
component companies in
Manaus

Market adjustment
(1998- )

Increase of import taxes


Incentives to export
Manaus tax incentives
extended until 2013

Consumer electronics
retail crisis (12 firms
closed in 1998)
New components plants
in Manaus
Protect the industry from
high cost raises due to
new duties

Strong price reduction in

Few players close

finished goods for the


increase of competition
High market growth
Growing trade deficit due
to input imports and low
exports

activities (Sharp
bankrupt, Cineral/
Daewoo leaving country)
after currency
devaluation in 1999
Increase in mobile phone
exports

36

Exhibit 10

LABOR PRODUCTIVITY COMPARISON BY SEGMENT**


Index*, Korea = 100
Mobile handset assembly**
100
52

n/a

n/a
In
di
a

C
h
in
a

n/a
M
ex
ic
o

B
ra
zi
l

M
al
ay
si
a

K
or
e
a

n/a

PCs and components assembly


Labor productivity (excl. mobile phones)
Value add/FTE
100
25

24

C
h
in
a

28

24

11
In
di
a

M
ex
ic
o

B
ra
zi
l

38

29

M
al
ay
si
a

34

K
or
e
a

40

100

13

In
di
a

55

C
h
in
a

34

35

In
di
a

61

M
ex
ic
o

B
ra
zi
l

K
or
e
a

47

M
al
ay
si
a

na

ex
ic

100

Ch
i

al
ay
sia
M

Br
az
i

Ko
re
a

Brown goods assembly

White Goods
100

C
h
in
a

19

17

12
In
di
a

34

M
ex
ic
o

B
ra
zi
l

M
al
ay
si
a

K
or
e
a

35

* Indexed to Korea = 100: Base measurement = RMB/worker/hour


** Koreas mobile handset industry definitions includes other wireless devices such as wireless broadcast transmitters and wireless closed
circuit cameras; Indias numbers are calculated using data of listed companies (largest); they may be biased upward because of this
Source: China: China Electrical Industry Yearbook; China Light Industry Yearbook; Korea: National Statistical Office, Electrical Industry
Association of Korea; Malaysia: Annual Survey of Manufacturing Industries, Department of Statistics; Brazil: IBGE, FIPE; McKinsey
Global Institute

37

Gap with best practice. Information laws which prohibited foreign


companies from operating in the Brazilian PC market created a very
weak field of domestic competitors, particularly in PCs. When these laws
were repealed in the early 1990s, Brazil drew in new international
companies such as Compaq and later Dell, thus increasing competition.
Factors that have discouraged FDI
Supplier base and infrastructure.
Brazil's significant production
infrastructure in high-cost Manaus which is encouraged by government
tax incentives for firms to produce there has discouraged investment in
export-oriented production in Brazil.
FDI IMPACT ON HOST COUNTRY
Economic impact
Sector productivity
Productivity level. The productivity of Brazilian consumer electronics
sector is 40 percent than of Korea, but higher than in Mexico, China, and
India. Brazil has higher productivity than China and Mexico because its
production capabilities are focused on the domestic market and do not
include the heavy mix of labor-intensive export goods featured in China
and Mexico. China's productivity, in particular, is further reduced by the
presence of unproductive state-owned enterprises (SOEs) (Exhibit 10).
Productivity growth. Labor productivity growth increased four percent per
annum in white goods, six percent in brown goods, and twelve percent in
PCs, during the years 1996-2001. However, the growth levels for white
and brown goods, as good as they are, are much lower than those seen
in both China and Mexico. Macroeconomic-instability and the energy
crisis have had strong impacts on Brazil, as consumption declined faster
than employment could be cut, especially in the period 1998-2000. PC
productivity has grown at a faster rate as volumes have risen. We would
expect that with the market downturn in 2002-2003 productivity growth
will slow again (exhibits 11-14).
We attribute productivity increases to FDI based on our interviews that
indicated both higher competitive intensity as well as manufacturing
improvements made by some FDI companies as drivers of productivity
growth (Exhibit 15).
Sector output
Domestic demand. Domestic demand continued to grow at an average
rate of 18 percent per annum from 1998-2001, with very high growth in
mobile handsets and PCs, high growth in white goods, and relatively flat
sales in brown goods. The strong growth in domestic demand coincided
with macroeconomic stabilization and an increased availability of
financing, so it is difficult to attribute it to FDI alone. The flattening off in
demand seen in 2001 coincides with the return of macroeconomicinstability resulting from the massive currency devaluation in Argentina
and Brazil's energy crisis (Exhibit 1).

38

Exhibit 11

WHITE GOODS PRODUCTIVITY 1996-2001

CAGR

Value added
2001 R$ Billions
2.6

2.6

-2%
2.0

2.5
2.2

2.0

-14%

Labor productivity
2001 R$ thousand per employee

8%
1996 1997 1998 1999 2000 2001

4%
65
52

54

53

46

-6%

52

12%

Employment
Thousands

1996 1997 1998 1999 2000 2001

51

-6%

47

43

41

40

38

-8%
-4%

1996 1997 1998 1999 2000 2001


Source: IBGE; FIPE; McKinsey Global Institute

Exhibit 12

BROWN GOODS PRODUCTIVITY 1996-2001

CAGR

Value added
2001 R$ Billions

3.1

-8%

2.3
1.8

1.6

Labor productivity
2001 R$ thousand per employee

1.5

-2%
1996 1997 1998 1999 2000 2001

6%

81

1.2

-16%

83

79

63

59

3%

52

7%
Employment
Thousands
1996 1997 1998 1999 2000 2001

39

38

-14%

26

23

22

20

-19%
-9%
1996 1997 1998 1999 2000 2001
Source: IBGE; FIPE; McKinsey Global Institute

39

Exhibit 13

PCs* PRODUCTIVITY 1996-2001

CAGR

Value added
2001 R$ Billions
32%
1.7
1.3
1.0

Labor productivity
2001 R$ thousand per employee
12%
1999

110
88

2000

2001

84

Employment
Thousands
18%
1999

2000

16

2001

15

11

1999

2000

2001

* Includes PCs, monitors and similar; printers, scanner and similar; data storage as diskettes or hard drives; keyboards
Source: IBGE; FIPE; McKinsey Global Institute

Exhibit 14

PRODUCTIVITY ANNUAL GROWTH RATE 1996-2000/2001*


China
Mexico
Brazil

CAGR Percent

39

30

19
14
6

White goods

Brown goods

* Figures are 1996-2000 for China and 1996-2001 for Mexico and Brazil
Source: INEGI; China Electrical Industry yearbook; China Light Industry yearbook; China Statistical Yearbook; IBGE;

FIPE; McKinsey Global Institute

40

Exhibit 15

PRODUCTIVITY INCREASE OF ACQUIRED COMPANIES - EXAMPLE


DISGUISED COMPANY

White goods produced / employee / year

Main changes for


productivity
increase

Opened Manaus
automated plant

Closed So Paulo

750

old plant

Invested in
400

Number of
employees

1996

2002

10,000

6,000

automation of
existing plants
Developed a more
professional
structure with
fewer employees

Source: Interviews

Exhibit 16

MARKET SHARE OVER TIME IN BRAZIL CONSUMER ELECTRONICS


Percent
PCs

Mobile handsets
1996

2001
Motorola

Gradiente
5
7

Samsung

23

Others
10 Ericsson

55

3 Nokia
NEC
Philips
Gradiente
33

1996
7

13

17
36

Nokia

Others

14 IBM

18

3 3 4 5

18

Ericsson

Microtec

Motorola

Metron

9
42

LG 8

Compaq

Compaq

TVs

HP UIS

Others

49

12 Itautec
Philco

8 IBM

7
3 4

Tropcom

Novadata HP

7 Itautec
Philco
Dell

Refrigerators

1995

2001

Others

1996

14

Semp Toshiba

20

10

53
20

CCE
16

Itautec
Phlco

13

Itautec
Phlco

Multibrs
(Whirlpool)

Multibrs
(Whirlpool)

36

17
14

Others
BS Continental
CCE
7 1
10

Electrolux

21

CCE

Sharp 11

10

Panasonic

Semp
Toshiba

2001

Others
Philips

Evadin
Mitsubishi

2001

Others

65

29

Philips
17

LG

Source: IDC; Semp Toshiba; interviews; 100 Maiores de telecomunicaes

Electrolux

41

Export performance. Brazil's total exports have increased strongly from a


relatively low level, due to growth in mobile handset exports. We attribute
this growth to FDI, as at least 90 percent of mobile handset production
in Brazil is controlled by multinational companies. Brazil is competitive in
mobile phones because of two factors: freight costs are less important in
the sub-segment; the relative weakness of the Real makes Brazilian
mobile handsets relatively less expensive for foreign countries to import
(exhibits 2 and 3).
Sector employment. Overall sector employment has decreased in Brazil at
a rate of about six percent per annum from 1996-2001 in white goods,
brown goods, and PCs. We attribute part of the reduction in employment to
FDI and to the economic recession. FDI companies, in some cases,
reorganized and automated production, thereby cutting employment and
increasing productivity (exhibits 11-13 and 15). The reduction in demand as
a result of economic downturn was also a significant factor.
Supplier spillovers. There is little evidence of significant supplier spillovers
in Brazil. In fact, Brazil is a heavy importer of consumer electronics
components.
Distribution of FDI Impact
Companies
FDI companies. FDI companies have gained share in Brazil in mobile
handsets, PCs, and TVs, while slightly losing share in refrigerators. Our
interviews indicate that FDI companies have mixed profitability in Brazil
with a few returning positive profits, and several others consistently
unable to make a return on their cost of capital. Overall, our evidence
suggests that FDI companies have benefited somewhat from entering
Brazil, at least in terms of market share gains (Exhibit 16).
Non-FDI companies. As a result of the increased competitive intensity,
particularly in the late 1990s, prices have declined as margins have
shortened and market shares have changed. International companies
have acquired certain domestic companies and the overall market share
of domestic companies has declined (Exhibit 16).
Employment
Level. As previously stated, employment in the sector has decreased.
Wage. Because of Brazil's macro-economic instability during the period
under review, it is not possible to assess the impact of FDI on wages for
FDI as compared to non-FDI companies.
Consumers
Prices. Prices have fallen in Brazil at a relatively quick rate at between
7-15 percent per annum in real terms since 1995. Prices remain above
U.S. levels in Brazil, but this is almost entirely due to Brazil's high taxes.
Given the rapid entry of FDI in this period and the unclear link between
macroeconomic-stabilization and prices we attribute some of the
decrease in prices to the increased competitive intensity spurred by the
influx of FDI3 (Exhibit 17).

3.

Our interviews confirm that the increase in FDI entry and heightened competition are directly
linked.

42

Exhibit 17

PRICING CHANGES IN BRAZIL


Real: 2003 R$ per unit

TV
Refrigerators
Mobile handsets*
Personal computers*

5000
4500

Prices have been

4000

CAGR

3500

3000
2500

- 15%

2000

1500

- 7%

1000

decreasing
steadily
PC price
reduction reflects
stronger
presence of grey
market
Mobile handset
price decrease
due to local
production

- 9%
- 15%

500
0

1995

1996

1997

1998

1999

2000

2001

2002

2003

* PC and mobile handset series data available from 1999 onwards


Source: IPC-FIPE; INPC; Extra (www.extra.com.br)

Exhibit 18

Sales financed

TV sales x interest rates

% of total consumer sales 2002

Sales in thousand and interest


rates in percent
150%

70
60
50
40
70
30
50
20
10
0

White
goods

Brown
goods

Nominal annual interest rate

80

Increase in
interest rates
have made
sales decrease

120%

9,000
Decrease in
interest rates
have helped
market recover

8,000
7,000

90%
6,000
60%
5,000
30%

4,000
3,000

0%
1997

1998

1999

2000

2001

2002

TV sales
Average interest rate for finished good purchase
Average interest rate for personal credit

Source: IBGE; interviews

Unit television sales (thousands)

IMPORTANCE OF FINANCING IN CONSUMER SALES

43

Product variety and quality. FDI had a definite impact in improving the
product variety and quality of PCs available in Brazil. This had been a
closed market until the early 1990s due to information laws. In other
segments, FDI has also increased variety and quality. Currently, new
white goods products are released from one of the manufacturers or
another every two to three weeks; prior to the influx of FDI, new products
appeared less frequently.
Government. Our analysis does not reveal what impact FDI has had on
government tax receipts in Brazil.
HOW FDI HAS ACHIEVED IMPACT
Operational factors. Interviews indicate that where acquisitions took place
FDI companies have improved productivity by automating plants and
consolidating operations. In one example, these changes induced a near
doubling of unit productivity between 1996 and 2002 (Exhibit 15).
Industry dynamics. The increasing number of FDI companies present in Brazil
heightened the level of competition in the mid-to-late 1990s, as indicated by
falling prices and changing market shares (Exhibit 16). Interview evidence
suggests that profitability fell across the consumer electronics segments in
Brazil during the time period under review.
EXTERNAL FACTORS THAT AFFECTED THE IMPACT OF FDI
There were a host of factors that negatively influenced the impact of FDI in Brazil,
including trade barriers, government incentives, labor markets, informality, and
cumbersome, heavy tax regulations. All of these factors reduced the price
competitiveness of Brazilian exports (where Brazil could have been
opportunistically competitive depending on exchange rate considerations). In
particular, informality reduced the competitiveness of FDI in the domestic market.
The relative success of Brazil in mobile handsets and compressors (e.g., those of
Embraco/Whirpool) shows Brazil's potential when the export infrastructure, labor
market and volatile demand issues are addressed.
Country specific factors
Key factors
Country stability. Though FDI was attracted to Brazil by the promise of
macroeconomic stability following the Plano Real, this macroeconomic
stability was fleeting. The instability has caused large swings in demand
that negatively impact productivity, as the size of the labor force is
somewhat fixed in the short-term. Macroeconomic stability and demand
are highly interrelated in Brazil. The majority of consumer electronics
purchases are financed; the high interest rates (that come with
macroeconomic instability) suppress demand (Exhibit 18). In addition to
the macroeconomic instability, the 2001 energy crisis forced consumers

44

Exhibit 19

SECTOR PERFORMANCE IMPORTANCE OF MANAUS IN BRAZILIAN


CONSUMER ELECTRONICS PRODUCTION
Production
Percent, $ billion

2
40

Rest of
Brazil

85

95

98

60

Manaus
15

Mobile
phones

PCs

Brown
goods

White
goods

Source: Suframa; McKinsey Global Institute

Exhibit 20

THE MANAUS FREE ZONE

Additional costs

Cost advantage*

Location

Percent
Manaus

Belm

100
15
6

So Paulo
80

Manaus is located in the middle of the

Cost
So
Paulo

IPI
tax
(15%)

VAT Inventory Import Freight** Cost


margin
cost *** tax + IPI
of imported
items

Amazon forest, approximately 2,500


miles from So Paulo, the main
consumer market
Trucks proceed to Belm by river
(5 days) then by road, taking
10-20 days to get to So Paulo
Freight cost between 3% and 7% for
consumer electronics products (except
white lines)

* Assuming non-white CE products with 25% of cost as imported components and 20% margin. Labor cost differences not
assumed
** Assume only extra freight cost compared to So Paulo
*** Assume 2 month component stock and 18 days delivery to south-east
Source: Interviews; McKinsey Global Institute

45

to cut power consumption in Brazil4. This also reduced demand for


energy-consuming consumer electronics products. This affected the
demand less in white goods (where some consumers opted to purchase
more energy efficient products) than it did in brown goods (where more
purchases were potentially foregone).
Government incentives. Government incentives in the form of VAT,
import tariffs and other tax rebates have encouraged production of
some goods in Manaus. A high percentage of brown goods and mobile
handsets are produced in Brazil; Manaus accounts for approximately 30
percent of total consumer electronics employment in Brazil. Manaus
production incurs a five percent freight penalty and two percent inventory
penalty (not including damage and additional obsolescence costs), as
parts take up to two months to reach Manaus from Asia (exhibits 19 and
20). In addition, labor is no less expensive in Manaus than in Sao Paulo.
In fact, skilled labor often needs to be imported, negating any low labor
cost advantage that one might expect in a remote area (Exhibit 21).
These factors make Brazil less competitive for exports and increases local
market prices. Government incentives also treat component shipments
from southern Brazil to Manaus as "exports" thus granting VAT rebates.
However, components made in Manaus must pay full VAT. This incentive
to make components in southern Brazil and transport them to Manaus for
final assembly encourages industry dispersion.
These incentives have proved an expensive way to increase employment
in Manaus, costing the government over $23,000 per direct job and
nearly $6,000 per indirect job created on an annual basis (Exhibit 22).
Cumbersome and heavy tax burdens. For some goods, full tax payments
can represent over 40 percent of the final good price (Exhibit 23). These
taxes negatively impact FDI by suppressing demand. In many cases, the
difference between U.S. and Brazilian prices is very close to the
difference in tax rates between the two countries (Exhibit 24).
Furthermore, in cases where rebates are offered, very cumbersome
recovery regulations exist. Companies need to put aside large cash
reserves for a significant period of time in order to cover these tax
rebates, thereby increasing their working capital costs. Also, significant
legal resources need to be dedicated to recover these rebates.
Secondary factors
Import barriers. Import tariffs have steadily declined from 20-30 percent
(depending on the product) in 1993 to around 20 percent in 2001
(exhibits 25 and 26). Even more harmful to Brazil are the unique Brazilian
standards for certain products such as PAL-M in color televisions
which mean that Brazilian production is incompatible with the standards
of other markets and cannot be easily exported. Brazil regards developing
local technology important and is considering a similar unique standard
for digital television.

4.

Most energy in Brazil is generated by hydroelectric power plants. As a result of rainfall shortages,
the government required industries and consumers to reduce energy intake by 35 percent.

46

Exhibit 21

AVERAGE CONSUMER ELECTRONICS WAGES DEVELOPMENT


Monthly salaries in real 2002 R$

CAGR (%)
Brazil
Manaus free zone
Manaus consumer electronics
So Paulo city
Belo Horizonte

1.2
1.2
1.1
-3.5
-1.8

1,150
1,050

Salaries have
950

850
750
650

increased in Manaus,
reflecting the
strength of unions
Absolute average
salary of Manaus is
comparable to that of
cities like So Paulo
or Belo Horizonte,
demonstrating high
labor costs

550
450
1995

1996

1997

1998

1999

2000

2001

2002

Source: Suframa; IBGE; DIEESE

Exhibit 22

EXTERNAL FACTORS TAX BENEFITS PROVIDED VS. JOBS CREATED IN


MANAUS

Total value of tax benefits to Manaus


CE companies 2001*

Tax subsidy per job


created - 2001

$ Million

$ Thousand/ job

576
58

Direct

23.6

212

Direct +
indirect
306

Import
tax

IPI

VAT

5.9

Tax breaks
probably
not
necessary to
attract
companies to
Brazil,
therefore they
represent real
costs to
government

Total tax
benefits

* Consider only components capital goods are excluded. Includes all electronic sectors made in Manaus,
finished products and components
Source: Suframa; ABINEE

47

Exhibit 23

THE PRICE BREAKDOWN FOR A CONSUMER ELECTRONICS PRODUCT


IN BRAZIL ASSUMING FULL TAXES PAYMENT*
EXAMPLE
Percent
4.2
18.0
9.2
0.4
1.0

Almost half of

5.3

the consumer
price are taxes

9.9
100.0

10.4

Some taxes
are added up
in all steps of
the chain, as
CPMF and
PIS/Cofins

41.6

Product
cost

Manufacturer Import
margin
tariff

Labor
tax*

CPMF
tax*

PIS/
Cofins
tax*

IPI tax

VAT tax

Retailer
margin

Consumer
price

Taxes represent
43.8% of consumer
price

* Consider taxes paid by both manufacturer and retailer


Source: Interviews; McKinsey Global Institute

Exhibit 24

PRICE COMPARISON OF CONSUMER ELECTRONICS GOODS IN US VS.


BRAZIL 2003
US$ *
Mobile handsets

PCs

$
-20%
312

Brazil

250

US

TVs

-26%
812
600

Brazil

US

Refrigerators
-36%

-16%
768

593
500

Brazil

US

495

Brazil

* R$/US$ rate used = 3.20


Source: US data: Best Buy; Brazil data: Ponto Frio; Extra; Lojas Americanas (Americanas.com)

US

48

Exhibit 25

IMPORT TARIFF EVOLUTION FINISHED PRODUCTS


Percent

Sound equipment
Video equipment
Refrigerators/freezers
Mobile handsets

80

Personal computers

70
60
50
40
30
20
10
0
1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Increase in taxes
in 1995 due to
heightened
negative trade
balance for
consumer
electronics,
focused on
categories
manufactured
locally
(refrigerators),
also to protect
local
manufacturers
from imported
and cheaper
products
(currency was
over-valued)

Source: Camex

Exhibit 26

IMPORT TARIFF EVOLUTION COMPONENTS


Percent
Printed circuits

30

Mother boards

25
20
15
10
5
0
1993

Source: Camex

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

49

Informality and enforcement. PCs are often constructed from parts


imported via Manaus tax-free and then assembled into a final product by
a small operation that also avoids taxes, rendering formal/FDI companies
uncompetitive in many market segments, and fostering a strong grey
market (at least 50 percent of total production). Grey markets refer to
the illicit, but technically legal, activities that are not reported to the tax
authorities and the income from which goes untaxed and unreported.
Interviews indicate that some Brazilian government agencies may even
support the grey market by purchasing computers from grey market
companies.
Labor market requirements. Requirements for substantial employee
benefits means that total employment costs are double the level of wage
compensation in Brazil. Furthermore, a limited supply of skilled
electronics engineers in Brazil limits Brazil's ability to produce export
goods.
Initial sector conditions. High inflation and the shield of a closed market
(particularly for PCs) reduced competition significantly prior to FDI entry.
Because the market was starting from an initial low level of competition, the
impact of FDI was increased.
SUMMARY OF FDI IMPACT
FDI impact has been positive in Brazil, increasing the level of competition and
fostering operational improvements, which has driven down prices for consumers.
The main beneficiaries of increased FDI have been the consumers who have
benefited greatly from declining prices. In terms of productivity, employment and
output, it is difficult to disentangle the impact of FDI from that of the market
stabilization that coincided with increased FDI. A host of external factors have
reduced the potential impact of FDI in Brazil by making Brazilian production less
cost effective. These factors include Brazil's unique standards, government
incentives, labor markets, informality/enforcement and cumbersome, heavy tax
burdens. They have also reduced the potential demand in Brazil by keeping prices
higher than they would be otherwise and have made Brazil less competitive as an
exporter.

50

Exhibit 27

BRAZIL CONSUMER ELECTRONICS SUMMARY


1

FDI entry encouraged in early 1990s in PCs due to repeal


of information laws entry gains speed in the second half
of the 1990s as the Plano Real brings economic stability
to Brazil; however, returned macro-instability and the
onset of an energy crisis in Sao Paulo (which required
consumers to reduce energy intake) hinder FDI
performance in the early 2000s

Additional players add competitive intensity, and gain


share vis--vis local players in PCs, white and brown
goods

External
factors
1

FDI

Industry
dynamics

FDI improves productivity through plant level operational


3
improvements in some cases

Government incentives that encourage production in


Manaus reduce industry efficiency in some goods;
furthermore, lack of tax enforcement gives advantage to
garage production of PCs

Dispersed and remote industry value chain hinders


Brazils ability to export many goods; exception is easily
transportable goods like mobile handsets

FDI impact has been positive in Brazil, increasing the


level of competition and fostering operational
improvements, which has driven down prices for
consumers. However, persistent macro-instability and
the energy crisis also continue to hinder sector
performance

6
Operational
factors
5
Sector
performance

Exhibit 28
++
+

BRAZIL CONSUMER ELCTRONICS FDI


IMPACT IN HOST COUNTRY

Economic impact

Growing
PreFDI
stabilization (1994(Pre-1994)
2001)

Sector productivity

N/a

FDI
impact
+

(CAGR)

Sector output

N/a

Productivity growing around 15% per year since

Growing in PCs and handsets, down in brown and


white goods; given increase in competition we
attribute some of this to FDI

N/a

[-]

[-]

(CAGR)

Suppliers

Evidence
1994 (these numbers are brand new and need to
be verified)

(CAGR)

Sector employment

[]

Highly positive
Positive
Neutral
Negative
Highly negative
Extrapolation

Employment drops due to FDI efficiency


improvements as well as macroinstabilitys impact
on demand

N/a

[-]

[0]

Supplier industries reduced due to trade opening


in supplier industries in early 1990s (cannot be
attributed to FDI)

Impact on
competitive
intensity (net
margin CAGR)

N/a

Prices declining rapidly; FDI brings some new


products to Brazil

51

Exhibit 29
++
+

BRAZIL CONSUMER ELECTRONICS FDI IMPACT IN


HOST COUNTRY

Distributional impact

PostPre/liberalizati
liberalization on (1994(Pre-1994)
2001)

FDI
impact

__
[]

Highly positive
Positive
Neutral
Negative
Highly negative
Extrapolation

Evidence

Companies
MNEs

N/a

[-/+]

[+/-]

MNEs profitability very mixed (interview results)

Domestic
companies

N/a

Local companies such as Itautec/Philco and CCE


have lost share; many others have been acquired

Employees
Level of
employment
(CAGR)
Wages

N/a

[0]

and handsets offsetting declines


N/a

[0]

[0]

Wages in Manaus (CE zone) have been growing


faster than in economy as a whole; not clear this is
due to FDI

Consumers
Prices
Selection

Employment relatively stable with growth in PCs

N/a
N/a

+
[+]

+
[+]

Prices falling rapidly in period


FDI has had some impact on selection, but
limited in many cases due to unique Brazilian
standards, import barriers

Government

N/a

[0]

[0]

Taxes

No clear impact of FDI on taxes, as many rebates


have been given

Exhibit 30

BRAZIL CONSUMER ELECTRNOICS COMPETITIVE


INTENSITY
PostPrior to focus
period (pre1994)

/liberalizatio
n (19942001)

Evidence

Profitability mixed
Pressure on
profitability

N/a

New entrants

N/a

Weak player exits

N/a

Pressure on
prices

N/a

Changing market
shares

N/a

Pressure on
product
quality/variety

N/a

Pressure from
upstream/downstream industries

N/a

Overall

N/a

N/a

High due to FDI


High not due to FDI
Low
Rationale for FDI contribution

Cannot be directly attributed to


FDI

Several new entrants in

All new entrants are FDI

brown and white goods

Weak player exits

n/a

observed in PCs

Average price steadily

n/a
declining, though may be
due to downgrading of
products
Market share shifts
FDI players play key role, though
significant In all four markets
some local players present
Sony brings only 70
SKUs of 15,000 to Brazil
due to import barriers and
macro-instability

Has contributed positively by


bringing handsets and better
PCs to market

52

Exhibit 31
++ Highly positive

BRAZIL CONSUMER ELECTRONICS


EXTERNAL FACTORS EFFECT ON FDI

Highly negative

( ) Initial conditions

Impact
on per
$ impact Comments

Impact on
level of FDI Comments
Level of FDI*
Global industry
Global
discontinuity
factors

Negative

+ Positive
O Neutral

Relative position
Sector Market size potential
Prox. to large market
Labor costs
Language/culture/time zone

+
0
0
0

One of the largest developing

(' in) Macro factors


Country stability

0
0
O
O

markets

Post stabilization many FDI

However, actual instability (in spite of

Product market regulations


Import barriers
Preferential export access
Country Recent opening to FDI
specific
Remaining FDI regulation
factors
Government incentives
TRIMs
Corporate Governance
Taxes and other

+
0
+
0
0
0
0
0

companies entered Brazil due to


expectation of stability
High trade barriers/standards made
entry through trade impossible
FDI liberalization in PCs in early
1990s drew some new players
Not clear that incentive affected
level of FDI, though it did cause
players to locate in Manaus

-O
O
O
0
0
0

expectations) hurt growth of markets; on the


positive side it helped exports in mobile
handsets
Standards make exports of some goods
impossible, even with favorable currency;
increase operating costs; protect weak players
Drew players to Manaus, where industry is
less cost effective (due to extra freight and
inventory costs)

Capital market deficiencies

Labor market deficiencies

Informality

Labor laws drive up cost of labor in Manaus,


where labor should be significantly cheaper

Supplier base/infrastructure

Lack of tax enforcement creates strong grey


market in PCs

Competitive intensity

0 (M)

Gap to best practice

+(M)

Sector
initial
conditions

0 (M)

Especially important in PCs

Leaves more room for productivity growth (all


+ (M)

else equal); one white goods manufacturer


nearly doubled productivity

Exhibit 32

BRAZIL CONSUMER ELECTRONICS


FDI IMPACT SUMMARY

[ ] Extrapolation ++ Highly positive

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

External Factor impact on


FDI impact on host country
Level of FDI relative to sector*

30

Economic impact

Level of FDI
Level of FDI** relative to GDP
Global factors

Sector productivity

Sector output

Sector employment

[-]

Suppliers

[0]

Impact on
competitive intensity

Distributional impact
Countryspecific factors

Companies
MNEs
Domestic

[+/]

Employees
Level
Wages

Consumers
Prices

(Selection)

[+]

Government
Taxes

0.11

Global industry
discontinuity

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

+
O
O
O

O
O
O
O

Macro factors
Country stability

Product market regulations


Import barriers
Preferential export access
Recent opening to FDI
Remaining FDI restriction
Government incentives
TRIMs
Corporate governance
Taxes and other

+
O
+
O
O
O
O
O

Capital markets

Labor markets

Informality

Supplier base/
infrastructure

[O]
[O]

[O]

* Average annual FDI/sector value added


** Average (sector FDI inflow/total GDP) in key era analyzed

Per $ impact
of FDI

-O
O
O

O
O
O

Competitive intensity

O (M)

O (M)

Gap to best practice

+ (M)

+ (M)

Sector initial
conditions

53

Exhibit 33

BRAZIL CONSUMER ELECTRONICS FDI OVERVIEW

Total FDI inflow (1996-2001)


Annual average*

$3.6 billion

Annual average per sector employee

$0.6 billion
30%
$5,880

Annual average as a share of GDP

0.11%

Annual average as a share of sector value added

Entry motive (percent of total)


Market seeking
Efficiency seeking

100%
0%

Entry mode (percent of total)


Acquisitions

35% (white goods)

JVs

5%

Greenfield

60%

* Includes 2 main sectors: Manufacturing of office equipment, PCs and related components; Manufacturing of
electronic and communication equipment; white goods are not included
Source: Brazilian Central Bank; IBGE; Interviews; McKinsey Global Institute

54

Mexico Consumer
Electronics Summary
EXECUTIVE SUMMARY
Mexican consumer electronics production grew strongly during the 1990s,
comprised primarily of exports to the U.S. During this time companies (mainly,
but not exclusively, American) set up export operations in Mexico to take
advantage of Mexico's low factor costs, proximity to the U.S. markets, and recent
entry into NAFTA5. FDI to the sector topped US$5 billion since 1994 and was
mainly efficiency-seeking. PC and peripherals production facilities were based
around Guadalajara, while audio and visual equipment operations were located
along the Mexico-U.S. border. In general, international companies entered
through greenfield investment, with the exception of American white goods
companies, which acquired existing plants.
FDI impact in the consumer electronics sector in Mexico has been very positive,
boosting output by an average of 27 percent annually, resulting in the creation of
an additional 350,000 jobs in the sector. It has also fostered a robust export
market with a net trade balance of roughly US $2 billion in 2000. Mexico's focus
on final assembly and processing has limited spillover impact on suppliers.
Mexican operations are primarily assembly/processing and are closely integrated
into North American supply chains and rely on the import of a number of
consumer electronics components from China. Both of these factors have
inhibited the creation of a robust local supplier base.
Mexico's role in the global consumer electronics sector hinges on its closeness to
one of the largest end user markets, the U.S. It does not have a large domestic
market, nor the low labor costs, tax advantages, and strongly integrated supply
chain of China. The recent economic downturn in U.S. consumer electronics
combined with China's entry into the WTO has begun to erode growth in Mexico's
consumer electronics sector. In order for it to continue to maintain its strong
position as an assembly location, Mexico will need to continue to improve
productivity and focus on products that can gain real benefits from Mexico's
proximity to the U.S. These benefits could consist of reduced transportation costs
or time or result from ease of interaction with the end users.
SECTOR OVERVIEW
Sector overview
The Mexican consumer electronics market grew strongly in the 1990s due
to a surge in consumer electronics exports as international companies set
up export operations to take advantage of Mexico's low factor costs,
proximity to the U.S. markets, and entry into NAFTA.
Total production of the sector was nearly US $35 billion in 2001, with a
very high percentage of local production being exported; 95 percent of
the exports went to the U.S. (Exhibit 1). Production is spread across all
goods, but is especially strong in TVs and PCs.
The local market in Mexico is about $10 billion (Exhibit 2).
5.

Mexico joined NAFTA in 1994.

55

56

Exhibit 1

CONSUMER ELECTRONICS GROSS PRODUCTION BREAKDOWN IN


MEXICO 2001
Brown goods

$ Billions

2
9

Total sector
Gross
production*

8
34
35

Finished good
imports

Total
exports**

Domestic
demand**

PCs
13

32

13
3
Gross
production*

Finished good
imports

Total
exports**

Domestic
demand**

White goods

10

3
1
Gross
production*

Finished good
imports

Total
exports**

Gross
production*

Domestic
demand**

Finished good
imports

2
2
Total
exports**

Domestic
demand**

Telecommunications
9

2
8

Gross
production*

* Includes domestic input, imported input and value added


** Includes finished and intermediate goods
Source: INEGI

Finished good
imports

Total
exports**

Domestic
demand**

Exhibit 2

CONSUMER ELECTRONICS MEXICO MARKET SIZE AND GROWTH


1998-2001
$ Billions
CAGR
Percent
9.6

16

2.3

68

1.9

11

3.1

16

Total:

6.0

Telecommunications

0.5

Brown goods

1.4

PCs

1.9

White goods

2.2

2.3

1998

2001

Note: Domestic market Includes finished goods and input


Source: INEGI

57

Total value added in production was $5.3 billion in 2001.


The sector's growth leveled off in 2001 after increasing by over 20 percent
per year between 1996 and 2000 (Exhibit 3). This was caused both by a
cooling in U.S. market demand and China's gaining market share in U.S.
consumer electronics (exhibits 4-6). Mexico continued to perform strongly
in a host of product segments vis--vis China. It gained market share in settop boxes and laser printers, among other industries, during the period
1998-2002. However, China took market share from Mexico in several
important industries especially TVs. China's gains in market share
accelerated markedly in 2002, as demonstrated by its nearly 3,000 percent
year-on-year growth in television exports to the U.S.
Mexico's consumer electronics sector can be characterized as "final
assembly/processing" focused. A relatively low percentage of total valueadded occurs in Mexico (Exhibit 7). Domestic value add is only 15 percent
of the total production value add, and domestic inputs represent only an
additional 14 percent of the total production value add.
FDI Overview
FDI characteristics
FDI to the sector averaged approximately $700 million per year from
1994 to 2001, with the entrance of a large number of contract
manufacturers post-1994 (exhibits 8 and 9). FDI in the consumer
electronics sector averaged seven percent of total FDI investments over
this period.
However, FDI in the consumer electronics sector was
volatile, ranging between two percent and twelve percent of total FDI.
Most major global companies have entered the Mexican consumer
electronics market and have dislodged (or acquired) all but one local
player (Alaska in PCs).
FDI is split among the four segments with high degrees of fluctuation from
year to year (Exhibit 10).
FDI plays primarily an efficiency-seeking role in Mexico, though FDI
companies certainly sell to the local market as well.
FDI impact quantification.
Because data on the consumer electronics
sector are scarce, we have relied primarily on interviews to make
assessments of the impact of FDI. The data analysis period we have used
is usually 1996-2001, for which data is readily available. We have stated
wherever this is not the case.
External factors driving the level of FDI. The key factors that drove FDI in
Mexico all relate to efficiency-seeking Mexico's low labor costs, its geographic
proximity to the U.S., and its signing of NAFTA. Each of these factors have
contributed significantly to Mexico's attractiveness and cost competitiveness as
a production location. In more recent times, its lack of developed supplier
industries and China's increasing integration into the consumer electronics
value chain have begun to harm Mexico's attractiveness for FDI.
Global factors. China has become increasingly integrated into the world
trading system and is starting to erode Mexico's competitiveness in
attracting FDI in some consumer electronics segments. This can be seen
particularly in some brown goods, such as TVs, where China is rapidly
gaining share and will therefore likely receive the incremental FDI needed to
expand its production further (Exhibit 6).

58

Exhibit 3

MAQUILADORA VS. NON-MAQUILADORAS IN MEXICAN CONSUMER


ELECTRONICS PRODUCTION
CAGR
Percent

Consumer electronics gross production in Mexico


Percent
35

35

17

47

12

53

24

29
27
50
23
Total
($ Billions)

56

53

16
59

Nonmaquiladora*

59
50

Maquiladora

41

Total
(billion
nom. pesos):

41

44

47

1996

1997

1998

1999

2000

2001

121

182

244

272

330

328

* Includes the production of all Mexican based companies except for maquiladoras; the non-maquiladora
production was adjusted based on the growth of the sector from 1994-2001
Source: INEGI

Exhibit 4

ORIGIN OF CONSUMER ELECTRONICS U.S. IMPORTS, 1999-2002


$ Billions

100
450
350

World

250
150
60
Japan
China
Mexico
Malaysia
Taiwan
Korea
Germany
France

0
1999

2000

2001

Note: *Input imports include brown goods, PCs, white goods and telecom products
Source: U.S. Trade online; McKinsey Global Institute

2002

59

Exhibit 5

SEVERAL KEY INDUSTRIES FOR MEXICO ARE THREATENED BY CHINA


Summary of Mexicos and Chinas share of U.S. imports, 2002

Threatened
industries

Growth
industries

Total U.S. Imports


Billion USD

Industry

Mexicos share
change 1998-2002
Percent

1. 20- 30 TVs

-22

2. Laptops

-16

3. Refrigerators

-14

4. Converters & decoders

-12

1.3

5. Satellite RX for TVs

-10

0.7

Mexico
Percent

1.4

China
Percent
10

77
9.4

13

0.4

85

12

53

74

6. 30 TVs

-8

0.7

91

7. Stoves

-6

0.5

83

8. Cellular phones

-2

9. Projection TVs

-2

10.4

1. TV top boxes

53

1.4

2. Laser printers
3. Digital Processing Units

45

1.5

36

15

27

1.9

6. Car CD players

18

1.8

7. Control units

14
13

9. Monitors

10

70

45

30

49

0.9

20

8. Display units

98

3.4

4. Car tape players


5. Digital switches

13

72

55

41

4.4

16

4.1

14

3.0

17
10
30

30

10. Parts for PCs

15

1.7

7.7

39

28

Source: US Trade online; McKinsey Global Institute

Exhibit 6

CHINA HAS RECENTLY THREATENED THE VITAL 20-30 TV SEGMENT


U.S.Television Imports from China and Mexico, 2001-2002
Thousand televisions
Size

Mexico

2001

10

466

14

155

2002
290
80
3,640

18-20
20-30

1,400
16,180

10

372

14

192
29

14,230
670
52

21

Total
Source: US Trade online; McKinsey Global Institute

~2,800%
growth in
one year

43
3,300

112

20-30
Projector

10,400

1,129

Projector

18-20

2,060
10,790

Total

China

Contested market

15
726

4,080

60

Exhibit 7

DOMESTIC VALUE ADD IN CONSUMER ELECTRONICS PRODUCTION IN


MEXICO
Percent, $ Billions
35

35

15

15

15

14

29
27
15
15

23

15

15
100% ($ Billions) =
Gross value added
Domestic input

17

16

16
15

71

70

18

70

68

69
68

Input imports

1996

1997

1998

1999

2000

2001

Source: INEGI

Exhibit 8

FOREIGN PLAYERS HAVE CONTINUED TO INVEST IN MEXICO


FDI in consumer electronics in Mexico
Billion USD

Ericsson
investment

1.6

8% CAGR

1.0

Peso
devaluation

U.S. recession
0.7
0.6

0.7

0.6
0.5

0.3

1994

1995

1996

1997

1998

1999

2000

2001

Billion
1
4
5
6
7
15
10
5
Pesos*:
% of total
2%
6%
6%
5%
6%
12%
7%
2%
FDI:
*The original data is in USD; therefore pesos were calculated multiplying dollars by each years average nominal currency
exchange rate
Source: Secretara de Economa; McKinsey Global Institute

61

Exhibit 9
NOT EXHAUSTIVE

KEY PLAYERS ENTRY INTO MEXICO CONSUMER


ELECTRONICS INDUSTRY

Contract manufacturing
era

HP started operations in
Mexico City (1965)

Local sales:

RCA opened a television and radio plant in


Mexico City (1952)
Philips Mexicana started operations
importing products like radios and
components from Europe (1939)
IBM started its operations
in Mexico City (1927)

Siemens founded a plant


in Puebla (1997)
Started manufacturing
television chassis and
wood cabinets in Tijuana
(1985)

Ericsson started operating


a telephone company in
Mexico (1904)

Domestic production

Maquiladora
introduction

1900-1960
Exports:

Siemens founded a plant


in Guadalajara (1994)

Transformation

1960-1980

Consolidation

1980s

Ericsson started
producing
telecommunications
equipment (1964)

1990-1994
SCI established as the
first Electronic Contract
Manufacturer in
Guadalajara (1990)

NAFTA phase 2
and U.S.
recession

NAFTA phase 1
1994-2000
Flextronics started
manufacturing
electronics in
Guadalajara (1995)

2001-onwards
Celestica started
manufacturing
electronics in
Guadalajara (2001)

Yamaver and Dovatron started


manufacturing electronics in
Guadalajara (1996)

RCA was one of the first


corporations to build in
the maquiladora industrial
sector of Jurez with a
component plant (1969)

Solectron and Jabil started


manufacturing electronics in
Guadalajara (1997)

IBM inaugurated the


Guadalajara plant (1975)

Mexikor started manufacturing


electronics in Guadalajara
(1998)

HP inaugurated a
microcomputer plant in
Guadalajara (1982)

Benchmark started
manufacturing electronics in
Guadalajara (1999)

Philips constructed
plants in the northern
border to increase
production (1987)

Omni started manufacturing


electronics in Guadalajara
(2000)

Source: Literature search; company websites; McKinsey Global Institute

Exhibit 10

BROWN GOODS AND TELECOMMUNICATIONS HAVE ATTRACTED MOST


FDI OVER THE PAST DECADE
Evolution of FDI by subsector
Percent
Total (Billion USD) =

0.3

0.6

PCs

10

5
15

Telecommunications

0.7

1.6

1.0

23

30

0.5

13

19

20

35
28

20
17

29

48

65

11

69
Brown goods

0.7

10

18
11

White goods

0.6

25

13

53
44

44
28

34
24

13
1994

Source: Secretara de Economa

1995

1996

1997

1998

1999

2000

2001

62

Country specific factors


Three country-specific factors have encouraged FDI and three have
discouraged it.
Proximity to large market. Mexico's proximity to the U.S. is the first key
factor that has encourages FDI. Its location eases communication and
reduces shipping costs and transportation time. This has been a key
factor in attracting investment into the maquiladora zones6 on the
border (where TVs are produced) as well as the PC production zone in
Guadalajara.
Labor costs. Mexico's labor costs are second factor in its favor. Though
they are not the lowest in the world, they do provide a significant
advantage over U.S. costs at approximately 10 percent U.S. levels.
Preferential export access. The third factor in its favor is that NAFTA
provides preferential access to U.S. markets. Though Mexico was already
a strong exporter to the U.S. prior to its signing NAFTA, its exports to the
U.S. have grown strongly since 1994 and many U.S. companies have
since made direct investment in Mexico since that date.
Supplier base. The first of the factors discouraging FDI is that Mexico's
supplier base is not as developed as China's. China benefits greatly from
the fact that Taiwan and Hong Kong based companies have established
basic supplier industries in China. Mexico is relatively disadvantaged as
it relies on American supply chain and Asian imports for most
components, without large local component production.
Infrastructure. Mexico faces problems in shipment of its goods. The
threat of theft occurring during the transportation of goods adds one
percent to overall goods costs due to increased security needs. This
reduces Mexico's competitiveness vis--vis China.
Labor market deficiencies. Under any circumstances, Mexico will have
higher cost labor than Asian rivals such as China. However, labor costs
are inflated by the requirement that has been imposed by the government
for companies to provide a high level of benefits.
Initial sector conditions
Given that the majority of Mexico's FDI is efficiency-seeking, the initial
conditions of the sector were not a major factor in attracting FDI in the
period under review.

6.

Maquiladoras were first established by the Mexican government in 1965 as part of the Border
Industrialization program to help increase employment opportunities for Mexican workers and to
boost the overall economy. Maquiladoras are foreign-owned assembly plants that were allowed
to import free of duty, on a temporary basis, machinery and materials for production or
assembly by Mexican labor and then to re-export the products, primarily back to the U.S. This
allowed foreign-owned companies to decrease their cost base by taking advantage of Mexico's
lower labor costs. Most plants are located on the Mexico-U.S. border.

63

FDI IMPACT ON HOST COUNTRY


Economic impact
Sector productivity. Mexico's overall sector productivity equals that of China
and is about one-quarter that of Korea. Compared to Korea, in both China
and Mexico the product mix reduces the productivity; in both, there is
concentration labor intensive assembly (accounting for 60 percent of
production in Mexico and 40 percent in China). China's productivity is further
lowered by its significant component of state-owned enterprises (SOEs),
which have lower productivity (Exhibit 11).
Productivity in the sector has been growing at an overall rate of 16 percent
per annum. At the sub-segment level, productivity growth in white goods is
14 percent per annum and in brown goods 19 percent per annum. In both
cases this is roughly half the rate of productivity growth seen in these subsegments in China over the same period (exhibits 12 and 13).
Sector output. Sector output continued to grow at an average of 27 percent
per annum in value add terms from 1996-2001, though it leveled off in
2001 (Exhibit 12). This growth can be attributed largely to FDI, as it is
fueled by exports of FDI companies.
Export performance. The level of Mexico's consumer electronics exports
to the U.S. had been growing until 2002, when it declined slightly.
China's level of exports to the U.S. has grown continuously. For many
high-volume commodity goods, China holds a production cost advantage
over Mexico. This is due mainly to lower factor costs, a more integrated
local supply chain, and tax advantages. Mexico's productivity which is
approximately equal to China's cannot compensate for China's
production advantages (Exhibit 14).
Supplier industries are much less developed in Mexico than in China. As
a result, its component logistics are more complex and costly; just-intime production7 more difficult to achieve. Furthermore, in some cases
Mexico imports components from the U.S., which implies higher transport
costs than would be incurred if the goods were produced locally and
implicit labor costs (exhibits 15 and 16). An example of this is television
tubes, where under NAFTA rules, all TVs imported from Mexico to the U.S.
that include tubes produced outside NAFTA attract a 15 percent tariff.
This virtually requires NAFTA sourcing for tubes and glass; Mexico's sole
source for tube glass are plants located in the Midwest of the United
States.
Chinese labor costs for skilled and unskilled labor are about 30 percent
those of Mexico. Furthermore, energy and land costs are also significantly
cheaper in China (Exhibit 17).
Productivity though growing in Mexico is growing even more rapidly in
China, and the productivity levels in the two countries are now nearly
equal (exhibits 13 and 14).
Multinational corporations, particularly those located in China's special
economic zones (SEZs), qualify for lower tax rates in China both in the
7.

Here just-in-time refers to producing the required parts, at the required time, in the required
amount, and at each step in the production process in order to decrease inventory costs.

64

Exhibit 11

LABOR PRODUCTIVITY COMPARISON BY SEGMENT**


Index*, Korea = 100
Mobile handset assembly**
100
52

n/a

n/a
In
di
a

C
h
in
a

n/a
M
ex
ic
o

B
ra
zi
l

M
al
ay
si
a

K
or
e
a

n/a

PCs and components assembly


Labor productivity (excl. mobile phones)
Value add/FTE
100
25

24

C
h
in
a

28

24

11
In
di
a

M
ex
ic
o

B
ra
zi
l

38

29

M
al
ay
si
a

34

K
or
e
a

40

100

13

In
di
a

55

34

C
h
in
a

35

In
di
a

B
ra
zi
l

61

M
al
ay
si
a

K
or
e
a

47

M
ex
ic
o

na

ex
ic

100

Ch
i

al
ay
sia
M

Br
az
i

Ko
re
a

Brown goods assembly

White Goods
100
17

12
In
di
a

C
h
in
a

19
M
ex
ic
o

B
ra
zi
l

34

M
al
ay
si
a

K
or
e
a

35

* Indexed to Korea = 100: Base measurement = RMB/worker/hour


** Koreas mobile handset industry definitions includes other wireless devices such as wireless broadcast transmitters and wireless closed
circuit cameras; Indias numbers are calculated using data of listed companies (largest); they may be biased upward because of this
Source: China: China Electrical Industry Yearbook; China Light Industry Yearbook; Korea: National Statistical Office; Electrical Industry
Association of Korea; Malaysia: Annual Survey of Manufacturing Industries; Department of Statistics; Brazil: IBGE, FIPE; McKinsey
Global Institute

Exhibit 12

CONSUMER ELECTRONICS PRODUCTIVITY GROWTH IN MEXICO


1996-2001
Consumer electronics value added evolution in
Mexico
CAGR
$ Billions
27%

1.5

2.4

3.1

3.6

4.6

4.9

Value added/employee
$ Thousands

16% CAGR

13.8

Billion
Pesos:

11.4

18.6

28.1

34.8

43.7

45.6

Consumer electronics employment evolution in


Mexico
Thousand employees
CAGR
9%

228

279

310

336

392

355

11.8

9.9

10.8

1997

1998

1999

2000

2001

66.8

90.8

103.5

111.3

128.6

1996 1997 1998 1999 2000 2001

8.4
6.6

1996
Thousand
Pesos:
49.9

1996 1997 1998 1999 2000 2001

* Dollars are calculated by dividing pesos/years average currency exchange rate


Source: INEGI

65

Exhibit 13

PRODUCTIVITY ANNUAL GROWTH RATE 1996-2001


Percent

China
Mexico

39

30

19
14

White goods

Brown goods

Source: INEGI; China Electrical Industry yearbook; China Light Industry yearbook; China Statistical Yearbook

Exhibit 14

SUMMARY OF EXPORT COMPETITIVENESS


Advantage

Description

China has a more developed supply chain across all electronic


industries

Unit manufacturing costs

Input Costs

Sources of cost advantage in inputs are logistics and factor costs


Mexico loses competitiveness on items it must import from the U.S.
(e.g., TV glass)

Productivity at very similar levels per both estimates and expert


Productivity

<=

interviews

China offers distinct cost advantages in labor (skilled and unskilled),


electricity and land costs

Factor costs

Mexicos geographic proximity to the U.S. as well as similar time zone


lower interaction costs with the U.S.

Other costs

Interaction costs

This is especially important for newer and customized products


Border zones provide shipping advantage
However, the geographical location advantage is far from being maximized
Furthermore, component logistics increase costs for Mexico

Transport costs

Mexico has tariff advantage (e.g., TVs) or parity (e.g., computers) with
Tariffs

=>

China

Income taxes on manufacturing are much lower in China than in Mexico


Taxes

66

Exhibit 15

TUBE GLASS MUST BE SOURCED FROM THE U.S., ADDING


SIGNIFICANTLY TO TOTAL COST PRODUCTION
Percent

Tube glass
manufacturers

100

10

120

Glass
cost
China

Higher
U.S.
labor
costs

Energy
and land
and
other
components

Higher
taxes*

Glass
cost
Mexico

*Considering a 34% tax in the U.S. and 15% tax in China


Source: McKinsey Global Institute

Exhibit 16

MEXICO IMPORTS MOST INPUTS FROM THE U.S. AND ASIA


Share of total inputs

Korea

40%

Japan

Shanghai
Shenzhen

60%

Component logistics are 30% more


Taiwan

U.S.
15%

China, Taiwan,
Korea, Japan,
Malaysia
20%
Source: Interviews

65%

expensive in Mexico due to the higher


logistic costs of bringing inputs from Asia
and the more expensive costs of U.S.
components
The main imported components are
electronic microcircuits and PCBs

67

Exhibit 17

OVERALL, FACTOR COSTS ARE HIGHER IN MEXICO THAN


IN CHINA, ACROSS THE BOARD
Factor cost comparison Mexico
Unskilled

Land

Energy

$ per hour

$/Sq.M manufacturing land


rent

US cents/Kwh ind. electricity


China

China

0.59

China

India

0.65

Malaysia

37.44

Mexico

1.47

Taiwan

37.68

Brazil

1.58

Mexico*

Malaysia

1.73

India

5.39

Taiwan
U.S.

3.76
4.98

Mexico

5.40

42.00

Korea

5.55

43.04

Taiwan

5.60

Malaysia

5.63

78.00

Brazil
21.33

U.S.

48.48

U.S.

6.44

Korea

33.00

94.53

Korea

Brazil

6.07

India

9.28

Mexicos factor costs are


more expensive than
Chinas across the board

* Average land cost in Ciudad Juarez, Chihuahua


Source: Lit search; EIU; ICBC; Monthly Bulletin of Earnings and Productivity Statistics (China); Taipower; WEFA WMM; DRI WEFA, Healy &
Baker; ILO; Malaysian Ministry of Human Resources; Central Bank of Malaysia; State Economic Development Corporations (Malaysia);
Malaysian Industrial Estates Bhd.; Malaysian Statistics of Electrical Supply; Tenaga Nasional (Malaysia); Folha de SP (Brazil); Aneel
(Brazil); Bancomext (Mexico); Expansion (Mexico)

Exhibit 18

HIGHER TAXES CONTRIBUTE TO THE HIGHER TOTAL COST


Tax burden on manufacturers/exporters
Percent
Mexico

China
34

33
24
15

China has a 0 0
Normal
income
tax

High tech*

Tax on
income in
special
zones

Tax on
income
in the
coast
line

3.4

Normal
income
tax

3.3
2.4

2.1

3% cost
advantage due
to tax breaks
The more
capital intensive
the good, the
greater Chinas
advantage

1.5
0

Maquiladora
tax on
revenues**

Normal tax on
revenues***

High tech Tax on


Tax on
Tax on
revenues*** revenues*** revenues***

*For the first 2 years


**For maquiladora (main exporter) considering the Safe Harbor scheme which taxes 34% on the higher of 6.5% of total assets
or 6.9% of total costs, and considering that total costs are 90% of revenues
***Considering a 10% profit margin
Source: Interviews; literature searches; McKinsey Global Institute

68

short and long term. Tax averages 10-15 percent (and sometimes 0
percent) in China while Mexican facilities are usually subject to U.S. or
Mexican tax rates of 34 percent (Exhibit 18).
Overall, for the U.S., China has approximately a 10 percent landed cost
advantage over Mexico in both TVs and PCs (exhibits 19 and 20).
Sector employment. Employment has grown at the rate of 9 percent per
year from 1996-2001 in Mexico and represents over 350,000 jobs. Given
the predominance of FDI export production in the total, FDI has had a strong
impact on employment (Exhibit 12).
Supplier spillovers. FDI has not been as successful in creating supplier
spillover benefits in Mexico as it has in China. Imported inputs still represent
70 percent of total production value in Mexico; in China it is closer to 50
percent. There are still no supplier industries in Mexico in such areas as
semiconductors, glass for TVs, and hard drives.
Distribution of FDI Impact
Companies
FDI companies. Its not clear how much incremental profitability FDI
companies gained due to their export activities from Mexico given that
the consumer electronics market in the U.S. (the major destination of the
exports) is quite competitive; the incremental profits due to relocation are
likely to have been eroded. FDI companies essentially control market
share in all segments in the Mexican domestic market, as the two large
white good companies were acquired in the 1990s, and the rest have
exited the market (Exhibit 21). The only exception to this is Alaska, a
Mexican manufacturer of PCs.
Non-FDI companies. Domestic companies have not played a role in the
export market. Nearly all the Mexican companies exited the market in the
early 1990s as the market was liberalized, limiting the impact FDI could
have had on them potentially.
Employment
Employment level. Mexican workers have been one of the biggest
beneficiaries of FDI in the consumer electronics sector, with over
350,000 jobs having been created there. Moving forward, a key question
is whether this job creation will continue (Exhibit 12).
Wages. Our data spans the period 1996-2001, where real wage growth
was modest. We have no data on how wages were affected by FDI prior
to this period (Exhibit 22).
Consumers
Prices. It is not possible to isolate the effect of FDI on prices in this
sector as FDI has been focused primarily on exports; market liberalization
brought both FDI and increased trade. Mexico's prices are within 10-20
percent of U.S. prices in white and brown goods, and sometimes even
lower than U.S. prices. However, in PCs and mobile handsets, Mexican
prices are considerably higher than in the U.S.
Product variety/quality. The same problem facing the examination of FDI's
price impact also applies to product variety and quality.

69

Exhibit 19

U.S. TV PRICE STRUCTURE CHINA VS. MEXICO


Indexed numbers
Mexicos advantages over China are
distribution and tariffs which are not
enough to compensate Chinas
advantages

Similar TVs

5-10

108-113

13
100

China

Tax*

Labor**

Energy +
land

Margin

Component
transportation

Tariff

Transportation of final
product

Mexico

* Considering a 34% income tax in Mexico and a 15% tax in China; includes taxes throughout the value chain
** Includes taxes throughout value chain; includes labor throughout the value chain
Source: Interviews; McKinsey Global Institute

Exhibit 20

U.S. PC PRICE STRUCTURE CHINA VS. MEXICO


Indexed numbers

Mexicos

Similar PCs

100

China

109
3

Income
tax*

-1

Transportation**

Labor***

Component
logistics

Mexico

advantage over
China is
transportation
which is not
enough to
compensate for
Chinas cost
advantages
Additional
advantage for
products with short
lifecycles like PCs
(obsolescence
concerns)

* Considering a 34% income tax in Mexico and a 0% tax in China


** Does not consider inventory costs for China; it considers transportation costs for Mexico from Guadalajara to
Laredo
*** Labor cost disadvantage much lower because many of the parts are imported from Asia
Source: Interviews; McKinsey Global Institute

70

Exhibit 21

CONSUMER ELECTRONICS MARKET SHARE BY SUBSECTOR IN MEXICO


2000
Percent

PC PCs
Total ($ Billions) = 2.1

Brown goods Televisions*


Total ($ Billions) = 1
Others

Others

32

Sony
8

10

HP

19

Panasonic

11

13

IBM

21

Sharp 9

13

Dell 6

Samsung

15

Compaq

28

15

Sanyo

JVC

Alaska

White goods Refrigerators


LG (1)
GOMO
7
Koblenz 7

Others

45

Comercial Acros
Whirlpool

Mabe

33
Local players sold to foreign
companies in 1990s

* Share of production not sales


Source: Euromonitor; Expansin; Gobierno de Baja California; McKinsey Global Institute

Exhibit 22

WAGES HAVE GROWN SIMILAR TO INFLATION


Consumer electronics wages evolution in Mexico
Pesos
Average
annual wage
18% CAGR

100,000

Consumer electronics
sector nominal

90,000
80,000

Maquiladora nominal

70,000
60,000
50,000
40,000

1% CAGR

30,000

Real wages*

20,000
10,000
0
1996

1997

1998

*Calculated using manufacturing salaries deflator


Source: INEGI

1999

2000

2001

71

Government. Given that many companies in the maquiladora zones do not


pay tariffs on components, income taxes, and property taxes to the Mexican
government, the impact of the consumer electronics industry on Mexican tax
income has probably been small. Other taxes such as payroll taxes may
have provided some benefits.
HOW FDI HAS ACHIEVED IMPACT
Operational factors. FDI achieved its greatest impact in Mexico by moving
production and the process knowledge, technology, and management
capabilities that went with them to Mexico. This transfer of operations
required capital. FDI also brought access to export channels in the U.S. market
through the established distribution and brands of U.S. companies.
Industry dynamics. When introduced in the early 1990s following market
liberalization, FDI brought increased competition, higher productivity, lower
prices, and better products to Mexico. In the process, it also eliminated many
local Mexican competitors who had been supplying the market when it was
closed to foreign companies.
EXTERNAL FACTORS THAT AFFECTED THE IMPACT OF FDI
Mexico's external environment was relatively liberal and did not strongly affect
the impact of FDI. The main factors hindering FDI in Mexico is its level of
infrastructure and the lack of supplier industries.
Country specific factors
Infrastructure. Because roadways are insecure in Mexico (with frequent
incidents of theft), one percent is added to costs to pay for the additional
security required. Mexican freight prices are generally much higher than
U.S. prices for similar distances.
Supplier industries. Supplier industries are not well developed in Mexico.
The resulting inventory-carrying costs of imported inputs add to the total
costs. Without well-developed supplier industries, Mexico also looses the
potential benefits of collaboration between suppliers and final goods
producers.
Initial sector conditions. These did not affect FDI, as foreign investment was
mostly made for efficiency-seeking reasons.
SUMMARY OF FDI IMPACT
FDI impact has been very positive in Mexico helping to boost output and
employment, bringing advanced production techniques, technologies, and
management skills to the country, and in providing access to export markets
(especially to the U.S.). Efficiency-seeking FDI (which is a large proportion of the
total in Mexico) is made in order to lower production costs; production will
therefore be moved if and when Mexico no longer offers those relative cost

72

advantages. It is likely that in the future more of the efficiency-seeking FDI for
commodity goods production will flow to China, as China holds manufacturing cost
advantages in many commodity consumer electronics goods. In order to continue
to be attractive to FDI, Mexico will need to maximize the advantages of its
proximity to the U.S. market. To do so it needs to improve its infrastructure and
become more focused on goods sensitive to transport costs and those requiring
greater interaction with (and proximity to) the consumers (exhibits 23 and 24).

73

Exhibit 23

Transport Cost Time Sensitive

MEXICO SOURCES OF COMPETITIVE ADVANTAGE IN CONSUMER


ELECTRONICS
Products that
Products that
Low value/
weight, volume

Rationale

favor Mexico

favor China

Goods that have low value/weight ratio

White goods
Medium/large television

Laptop computers

sets
Telephone switches

Portable radios
Mobile phones

Car CD and tape players

N/A

Desktop computers
Laptops
Cellular phones

White and brown

Telephone switches
Industrial electronics

CTVs

are relatively more expensive to ship

Mexicos auto industry has sustainable


Auto
electronics

Short
obsolescence
cycle

Interaction Sensitive

High
customization/
early lifecycle

geographic advantage, they benefit


from having integrated electronics
supply

Shipping via sea takes 6 weeks for


China vs. just days for Mexico; short
obsolescence cycle items lose their
value to quickly

Due to proximity to U.S. frequent


interaction needed for early life-cycle
goods will be easier

Because of long lead time from China,


High demand
volatility

(air shipment)

high demand volatility items will be


difficult to manage
Mexicos underdeveloped supplier
industries may neglect some of this
advantage

goods

Desktop computers
Laptops
Cellular phones

Exhibit 24

POTENTIAL OPPORTUNITIES FOR MEXICO CONSUMER ELECTRONICS


Mexicos
opportunities

100%

Phones
Monitors

Mature import market

Audio for cars


Leveling import market

Imports as a share of
domestic market, 2001

Laser printers
TVs

Product
lifecycle
Peripherals

Computers
Local production
market

Refrigerators

Emerging opportunities

Switches
-100%

0%
Imports growth, 1997-2001

Source: U.S. Census Bureau; McKinsey Global Institute

100%

74

Exhibit 25

MEXICO CONSUMER ELECTRONICS SUMMARY


1 Large amounts of FDI are drawn to Mexico due to
geographic proximity to U.S., low labor costs, and the
signing of NAFTA. Furthermore, domestic market
liberalization in the early 1990s allows foreign
competitors to compete in the domestic market

External
factors
1

2 FDI drives all domestic market participants out of


market with superior products

FDI

3 FDI focuses on export markets and drives strong

Industry
dynamics

growth in productivity, output/exports and employment

4 FDI impact has been very positive in Mexico


4
Operational
factors
3

Sector
performance

helping to boost output and employment, bringing


advanced production techniques, technologies,
and management skills to the country, and in
providing access to export markets (especially to
the U.S.). However, Chinas entry to WTO and a
slowdown in the U.S. flattens Mexicos output and
employment growth. Furthermore, the lack of local
supplier industry development probably due to
capital market inefficiencies hurts Mexicos
competitiveness. Mexico will likely be forced to shift
its focus from commodity production to products that
maximize its advantage of being close to the United
States

Exhibit 26

MEXICO CONSUMER ELECTRONICS FDI OVERVIEW

Total FDI inflow (1994-2001)

$6 billion

Annual average

$0.75 billion

Annual average as a share of sector value added

15%

Annual average per sector employee

$2,800
0.12%

Annual average as a share of GDP

Entry motive (percent of total)


Market seeking

5%

Efficiency seeking

95%

Entry mode (percent of total)


Acquisitions

5%

JVs

0%

Greenfield

95%

75

Exhibit 27

MEXICO CONSUMER ELECTRONICS FDI IMPACT IN


HOST COUNTRY

Distributional impact

Preliberalization
(Pre-1990)

Sector productivity

n/a

Post-NAFTA/
liberalization
(1990-2001)

FDI
impact

(CAGR)

Sector output

n/a

++

++

Evidence

Sector productivity growth rapid,

Sector output growth very high,


exports to U.S. account for over
70% of total output

n/a

++

++

(CAGR)

Suppliers

[]

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

though remains focused on lower


value add assembly

(CAGR)

Sector employment

++
+

Over 350,000 jobs in electronics


sector, with a rate of growth of 9%
over time period

n/a

Most of content is still imported; very


minimal supply base building in Mexico

Impact on
competitive intensity
(net margin CAGR)

n/a

[+]

[+]

FDI players partially contributed to


increased competitive intensity; sector
competitive intensity increased radically
after policy liberalization

Exhibit 28

MEXICO CONSUMER ELECTRONICS FDI IMPACT


IN HOST COUNTRY (CONTINUED)

Distributional impact

Preliberalization
(Pre-1990)

Post-NAFTA/
liberalization
(1990-2001)

FDI
impact

++
+
O

[]

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

Evidence

Companies
MNEs

n/a

[+]

[+]

initially should have gained from lower


factor costs (though likely competed
away by now)
Local companies did not survive
opening up of the market to imports
However, this impact is attributable to
policy change, not largely efficiencyseeking FDI production in Mexico

n/a

n/a

++

++

Over 350,000 jobs in electronics sector,

n/a

[O]

[O]

No evidence on changes in wages

Prices

n/a

[+]

[0]

Prices declined after policy liberalization,

Selection

n/a

[+]

[+]

yet this is not attributable to efficiency


seeking FDI

Government

n/a

[O]

[O]

Due to taxation rules, maquila production

Domestic companies

[0/-]

MNEs profitability not known, but

Employees
Level of employment
(CAGR)
Wages

with a rate of growth of 9% over time period

Consumers

Taxes

does not pay Mexican income tax,


meaning tax benefits have been extremely
low (limited to payroll type taxes)

76

Exhibit 29
High due to FDI
High not due to FDI

MEXICO CONSUMER ELECTRONICS


COMPETITIVE INTENSITY
Prior to
focus period
(1980-1995)

End of focus
period
(1994-2001)

Pressure on
profitability

n/a

n/a

New entrants

n/a

Weak player exits

n/a

Pressure on
prices

n/a

n/a

Changing market
shares

n/a

n/a

Pressure on
product
quality/variety

n/a

Pressure from
upstream/downstream industries

n/a

Overall

n/a

Low

Evidence

Profitability data not

Rationale for
FDI contribution
n/a

available for any


players in market

New entrants across


all segments which
were formerly closed

All Mexican CE

All new entrants


are FDI

Due to the

players except
one exit

entrance of FDI

Historical prices difficult

n/a

to track in Mexico

Historical market share

n/a

not available

Large variety of CE

n/a

products available in
Mexico

Exhibit 30

MEXICO CONSUMER ELECTRONICS


EXTERNAL FACTORS EFFECT ON FDI
Impact on
level of FDI Comments
Level of FDI*
Global industry
Global
discontinuity
factors
Relative position
Sector Market size potential
Prox. to large market
Labor costs
Language/culture/time zone
(' in) Macro factors
Country stability
Product market regulations
Import barriers
Preferential export access
Countryspecific Recent opening to FDI
factors
Remaining FDI regulation
Government incentives
TRIMs
Corporate Governance
Taxes/other

Continuing disaggregation of

++ Highly positive

Impact
on per
$ impact

Negative

+ Positive

Highly negative

Neutral

( ) Initial conditions

Comments

value chain may shift some


ops from Mexico to China
O
++
+
O

Market seeking not major driver


U.S. proximity drives investment
Low labor costs relative to U.S.

O
O
O
O

Liberal policies and more stable

peso increased attractiveness to FDI


O
++
O
O
O
O
O
O

Capital deficiencies

Labor market deficiencies

NAFTA crucial factor in drawing


more FDI

O
O
O
O
O
O
O
O
O

Labor market does have some

rigidities, but lack of skilled labor


may be a factor
Informality

Supplier base/infrastructure

Underdeveloped supplier base

starting to hurt Mexico vis--vis


China
Sector
initial
conditions

Decreases efficiency and opportunity for


FDI-driven exports; insecure physical
infrastructure increases costs

Competitive intensity

O (M)

O (M)

Gap to best practice

O (M)

O (M)

77

Exhibit 31
[ ] Estimate

MEXICO CONSUMER ELECTRONICS


FDI IMPACT SUMMARY

++ Highly positive

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

External Factor impact on


FDI impact on host country
Level of FDI relative to sector*

Level of FDI

Economic impact

Global factors

Sector productivity

Sector output

++

Sector employment

++

Suppliers
Impact on
competitive intensity

[+]

Distributional impact
Countryspecific factors

Companies
MNEs

[+]

Domestic

[0/]

Employees
++

Level
[

Wages

Consumers
Prices

[0]

(Selection)

[+]

Per $ impact
of FDI

0.12

Level of FDI** relative to GDP

15%

Global industry
discontinuity

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

O
++
+
O

O
O
O
O

Macro factors
Country stability

Product market regulations


Import barriers
Preferential export access
Recent opening to FDI
Remaining FDI restriction
Government incentives
TRIMs
Corporate governance
Taxes/other

O
++
O
O
O
O
O
O

O
O
O
O
O
O
O
O

Capital deficiencies

Labor market deficiencies

Informality

Supplier base/
infrastructure

Competitive intensity

O (M)

O (M)

Gap to best practice

O (M)

O (M)

Sector initial
conditions

Government
Taxes

* Average annual FDI/sector value added


** Average (sector FDI inflow/total GDP) in key era analyzed

Exhibit 32

EVOLUTION OF THE MEXICAN CONSUMER ELECTRONICS SECTOR


Import substitution

1940
External
factors:

Market liberalization

1985

Strict trade & FDI controls


Maquila program with tax/

Conduct:

1994

???

2001

Mexico joins GATT (1986)


New FDI legislation (1993)
NAFTA (1994)

Peso devaluation (1995)


U.S. economic boom

Slow revaluation of peso


U.S. recession
China joins WTO

Oligopolistic supplier base

Consolidation and

Integration of Mexico to

Exit of some players as

for domestic market:


foreign players with >50%
market share
Maquila operations strictly
export oriented assembly
operations of foreign players
along the U.S. border

rationalization of domestic
market supply base
Little change in maquila
structure

global production network


of foreign players
Convergence of domestic
and maquila operations in
regulatory treatment

Low competitive intensity

Increased competitive

Investment boom driven by

tariff benefits to generate


foreign exchange
Structure:

Expansion

under tariff/ quota price


umbrella for domestic market
Maquila operation closely
integrated to U.S. production
network

Performance: For domestic market, high cost


production due to sub-scale
plants and strict domestic
content requirements
Maquila operations value add
limited to labor: practically no
local inputs

intensity with growing imports

NAFTA expectations

production is moved away


from Mexico to Asia

Increasing competitive
intensity from Asian imports

Shift to imported inputs and


production for export even
outside maquila sector

Closure of lower productivity Rapid growth and


operations improves sector
productions

modernization of production
base

Eroding global
competitiveness of Mexican
operations

78

China Consumer
Electronics Summary
EXECUTIVE SUMMARY
The US $40 billion Chinese domestic consumer electronics market has been
growing annually at 20 percent, attracting a flood of market-seeking FDI in the
past 10 years. China's low labor costs, combined with a skilled labor force who
have been able to develop/maintain a comparative advantage in consumer
electronics, have made China an attractive production location, particularly for PC
and peripheral components (e.g., motherboards and keyboards). Market-seeking
and efficiency-seeking FDI, concentrated primarily in brown goods, white goods,
and mobile handsets, have created a virtuous cycle of rapid growth in the Chinese
consumer electronics sector, which is steadily transitioning from pure assembly
operations to cover the full value chain of parts production, including some
semiconductors.
FDI impact has had a very positive on the sector in China, helping it build a more
robust supplier base, bring in new technologies, and increase the product
selection. It has contributed 3.2 percent growth in employment and has fostered
operational improvements that have led to 39 percent productivity growth in
brown goods and 30 percent in white goods. The international companies'
interaction with domestic companies has created a genuine global success story.
These international companies played a critical role in establishing China as the
production base for the global distribution of their consumer electronics products,
moving their full supply value chain to China. The domestic companies have in
turn created a very competitive industry dynamic that has led to rapid productivity
growth among all sector's companies and has created razor-thin margins in the
Chinese markets. Chinese consumers and consumers world-wide are the real
beneficiaries of this highly competitive market.
China is a prime success story of how FDI together with a thriving domestically
owned sector have led to the creation of one of the leading production centers for
consumer electronics, including the full value chain of parts production.
SECTOR OVERVIEW
Sector overview. The Chinese consumer electronics sector has experienced
a period of rapid growth since 1995. This has been driven both by strong
domestic demand and surging exports.
Total finished goods production in the sector in China was over $60 billion
in 2000.
The domestic market (defined to include mobile phone handsets, PCs and
peripherals, brown goods, and white goods) is approximately $40 billion and
has grown at approximately 20 percent per annum since 1995. The white
goods market is the largest at nearly $16 billion in 2000, while brown
goods, PCs, and mobile handsets each contribute approximately $8 billion
(Exhibit 1).
Consumer electronics exports have surged, growing to $25 billion in 2000.
Imports have increased more rapidly over the time period under review, as
many technological inputs (e.g., semiconductors) still need to be imported

79

80

Exhibit 1

CHINA CONSUMER ELECTRONICS MARKET GROWTH BY SUBSEGMENT


$ Billions

CAGR
Percent
40.8

20.3

5.6

8.0

42.5

10.3

8.1

29.4

8.7

16.6

12.9

38.6

28.9
4.1

Mobile
phone
PCs
Brown
goods
White
goods

22.1
2.5
3.4

19.5
1.9
3.0

4.3
8.9
8.4

5.8

4.7

12.0

15.9

10.5

13.9

9.8

1996

1997

1998

1999

2000

Source: China Light Industry Yearbook; UN PC TAS; McKinsey Analysis

Exhibit 2

FINISHED GOODS TRADE IN CHINA CONSUMER ELECTRONICS SECTOR


$ Billions, 2000
Consumer electronics exports
CAGR 22%

25.0

Total China trade, 2000 = U.S. $474.3 billion

11.2

6%

Consumer
electronics

1996

13.9

1997

16.4

1998

18.7

1999

2000

CAGR 31%
5.3

Consumer electronics imports


3.9

Source: UN PCTAS database

1.8

1.7

1996

1997

2.4

1998

1999

2000

81

at this point (exhibits 2 and 3).


Value add in the domestic market appears to be increasing as supplier
industries are built up in China, indicating that China is creating (albeit
slowly) a role for itself as more than just a final goods assembler. A majority
of component imports are used for products consumed in the fast growing
domestic market (Exhibit 4). Value add in trade has expanded from $8
billion to $12.8 billion over the time period. Value add in China was
approximately 20 percent in final production, and another 30 percent in
inputs representing $12 billion and $18 billion in 2000, respectively.
FDI Overview. China's market has attracted a large number of international
companies that have contributed very significant levels of FDI to the consumer
electronics sector. China has acquired FDI both from market-seeking
investment, due to its large local market, as well as efficiency-seeking
investment for companies, looking to gain from low factor costs.
FDI characteristics
FDI flows to the consumer electronics sector have been extremely large,
reaching nearly $14 billion in 2001. This figure was driven by
considerable commitments from investors, particularly in inputs (e.g.,
semiconductors) but also in final goods (Exhibit 5). FDI to China averaged
15 percent of GDP and $6.5 billion per annum over the period under
review, as compared to an average of under $1 billion per annum in
Mexico, Brazil, and India.
Nearly all the international companies that have entered China have done
so across a number of product segments. They have, in general, chosen
to enter through joint ventures with local companies, whether this is
required by the government (as in mobile phones and formerly in PCs) or
not (as in brown and white goods) (Exhibit 6). More recently, a few
international companies have established wholly-owned subsidiaries
(e.g., Dell).
Investors from Japan, Europe, the U.S., and Korea have established
production facilities in China for mobile handsets, white goods, and
brown goods for sale primarily in the domestic market (market-seeking
FDI). In contrast, investors from Taiwan and Hong Kong have established
production in China to capitalize on efficiency gains, particularly important
in PCs and peripherals, primarily for global sale of their products
(efficiency-seeking FDI).
Most of the efficiency-seeking FDI in consumer electronics has been
focused on two geographical areas Shenzhen, in southern China, which
dominated early on and, more recently, Shanghai, which has since been
a large recipient of FDI. Market-seeking FDI has been slightly more
scattered, with joint ventures being established in various regions of
China.
FDI impact quantification. Given that FDI inflow has been relatively
smooth, we do not depend on contrasting two periods to highlight the
impact of FDI; instead we will use comparisons of FDI dominated sectors to
non-FDI dominated sectors and FDI-companies to non-FDI companies to
attempt to isolate the impact of FDI.

82

Exhibit 3

ANALYSIS OF NET TRADE IN CHINESE CONSUMER ELECTRONICS


SECTOR, 2000
Finished goods
$ Billions
25.0
5.3

19.7

Overall consumer electronics


Exports

Imports

39.2

Net exports

37.5

Inputs
$ Billions

14.2

Largest imports include:


Semiconductors
40%
TV/telecom parts
11%
Diodes/transistors
8%
Sound recording equip- 7%
ment parts
Printed circuits
5%

1.7
Exports
Percent
of exports

Imports

100

Net exports

91

19

Consumer electronics
trade surplus
of ~5%*

Exports

-32.2
Imports

-18.0

Net exports

* Actual trade balance in consumer electronics may be higher, as some input imports (e.g. semiconductors, diodes,
printed circuit boards) are used in other sectors (e.g. telecom infrastructure, medical devices)
Source: UN PCTAS database; McKinsey analysis

Exhibit 4

USES OF CHINAS CONSUMER ELECTRONICS INPUT IMPORTS


$ Billions

Value of production for domestic


consumption
Domestic
~65% production for
local
markets

Import
of inputs

Value add for


domestic
consumption

Domestic production
Imported input for
domestic production

45
40
35
30
25
20
15
10
5
0

China's value add in

1996 1997 1998 1999 2000

Total parts import

Value add of finished goods exports

40
35
30
25
20
15
10
5
0

Domestic
production for
~35%
export

Finished good exports


Imported input for
finished good export

30
25
20

12.8

15

exports is higher than


macro net exports
figures may indicate
However substantial
domestic market
growth has helped
fuel input import
growth
Chinas overall
consumer electronics
trade surplus percent
will grow strongly if it
meets its goals for
input self sufficiently
for domestic
consumption (e.g.,
50% of
semiconductors
demand produced
locally by 2010)

10
1996 1997 1998 1999 2000

8.0

0
1996 1997 1998 1999 2000
Source: UN PCTAS database; McKinsey analysis

Finished goods
value add for export

83

Exhibit 5

COMMITTED FDI IN CHINA CONSUMER ELECTRONICS SECTOR*


$ Billions
13.7
11.4

Percent of Total
FDI to China
Utilized FDI
($ billions)

2.9

2.9

1996

1997

4.0%

5.8%

n/a

n/a

Semiconductor fads
drove investment
higher in 2000 and
2001 (examples:
Grace semiconductor
$1.6 billion, SMIC
$1.5 billion)

4.4

4.0

1998

1999

2000

2001

8.5%

9.6%

18.2%

19.9%

2.4

3.2

4.6

7.1

* Includes Electronics and Telecommunications Equipment


Source: China Foreign Trade and Economy Yearbook

Exhibit 6

OWNERSHIP PROFILE OF MAJOR CONSUMER ELECTRONICSPLAYERS


IN CHINA
Foreign owned

JV

Non-FDI

Motorola

TCL

HP
Dell

IBM/Great Wall
Toshiba/Toshiba Computer

Mobile
phone

(Shanghai)

PC's

Legend
Founder
Tongfang

Epson/Start
Taiwan GVC/TCL

Brown
goods

Siemens
White
goods

Motorola/Eastcom
Nokia/Capitel, Southern
Siemens/MII subsidiaries
Samsung/Kejian
SAGEM/Bird*

Sony/SVA (Jingxing)
Philips/Suzhou CTV
Toshiba/Dalian Daxian
Great Wall Electronics/TCL

Samsung/Suzhou Xiangxuehai
Electrolux/Changsha Zhongyi
LG/Chunlan
Mitsubishi/Haier
Sanyo/Kelon, Rongshida
Sigma/Meiling
Hong Leong (SG)/Xinfei
Toshiba Carrier/Midea

Changhong
Konka
Hisense
Skyworth
Haier
Panda
Xoceco
Changling
Gree

* Bird began as a standalone Chinese company in 1992 (mobile handset production began in 1999), and only recently (November 2002)
entered a JV with Frances Sagem (Bird-Sagem Electronics) to boost production capacity
Source: Company data, literature search

84

Exhibit 7

MARKET SHARE OF LOCAL PLAYERS VS. MNCS IN SELECTED


PRODUCTS
Nascent
technology

Evolving
technology

Mature
technology

12

Locals

69
79

80

88

MNCs

Mobile
phones

31

21

20

PCs

TVs

Refrigerators

Source: China Statistical Yearbook; MII; Gartner; Sino Market Research; McKinsey analysis

85

FDI dominated vs. non-FDI dominated. We will highlight the differences


in the performance of the subsegments to isolate the impact of FDI
(Exhibit 7).
- FDI dominated. Mobile handsets where FDI players currently control
over 80 percent of the market.
- Non-FDI dominated.
White goods and brown goods have
approximately 70 percent and 80 percent non-FDI player share,
respectively.
- Mixed. Though non-FDI players dominate the PC market in China,
exports represent over half of production and are dominated by FDI
players. We, therefore, classify this as a mixed industry.
FDI-companies vs. non-FDI companies. In many cases we have no
company level data, and we cannot make direct comparisons between
these two segments.
External Factors driving the level of FDI. China's market size was the key
to drawing market-seeking, and labor costs strongly attracted efficiencyseeking FDI.
Furthermore, as supplier industries and export friendly
infrastructure (in special economic zones SEZs) developed in China, they
reinforced China's strong ability to attract FDI.
Global factors. As China becomes more integrated into world trade,
companies have increasingly sought to offshore commodity production to
lower cost locations. This has benefited China, which has extremely low
labor costs combined with a skilled labor force. This has enabled China to
maintain and develop a comparative advantage in consumer electronics
production. Over time, these factors have encouraged production to move
away from the relatively higher cost border zones to cheaper regions. As PC
companies outsourced production increasingly to contract manufacturers,
cost competition in manufacturing forced more production to lower cost
locations, also benefiting China.
Primary and secondary country-specific factors. A number of countryspecific factors have contributed to China's consumer electronics sector
being attractive for FDI. We have divided these into primary and secondary
factors.
The first of the two primary factors is that China's consumer electronics
market is very large over $40 billion in 2000 and has grown rapidly
in recent years. The sheer size and growth of the market has been key
in attracting market-seeking FDI.
The second of the primary factors is its low labor costs less than
one-third the level of Mexico and Brazil and on par with India. This has
proved highly attractive to efficiency-seeking FDI.
A secondary factor is China's cultural and linguistic links with Hong Kong
and Taiwan which have been key sources of investment, increasing the
overall level of FDI. Hong Kong was particularly supportive in building the
low-end electronics industries (e.g., calculators, computer speakers).
Another factor has been that the clustering of supplier industries in
particular areas has created greater scale-building these industries. This
has produced a virtuous cycle that has attracted other suppliers to these
areas, as well as final goods manufacturers, which have relocated to the

86

Exhibit 8

LABOR PRODUCTIVITY COMPARISON BY SEGMENT**


Index*, Korea = 100
Mobile handset assembly**
100
52

n/a

n/a
In
di
a

C
h
in
a

M
ex
ic
o

B
ra
zi
l

n/a

M
al
ay
si
a

K
or
e
a

n/a

PCs and components assembly


Labor productivity (excl. mobile phones)
Value add/FTE
100
25

24

28

C
h
in
a

24

11
In
di
a

M
ex
ic
o

B
ra
zi
l

38

29

M
al
ay
si
a

34

K
or
e
a

40

100

13

In
di
a

55

C
h
in
a

34

35

In
di
a

61

M
ex
ic
o

B
ra
zi
l

K
or
e
a

47

M
al
ay
si
a

na

ex
ic

100

Ch
i

al
ay
sia
M

Br
az
i

Ko
re
a

Brown goods assembly

White Goods
100

C
h
in
a

19

17

12
In
di
a

34

M
ex
ic
o

B
ra
zi
l

M
al
ay
si
a

K
or
e
a

35

* Indexed to Korea = 100: Base measurement = RMB/worker/hour


** Koreas mobile handset industry definitions includes other wireless devices such as wireless broadcast transmitters and wireless closed
circuit cameras; Indias numbers are calculated using data of listed companies (largest); they may be biased upward because of this
Source: China: China Electrical Industry Yearbook, China Light Industry Yearbook; Korea: National Statistical Office, Electrical Industry
Association of Korea; Malaysia: Annual Survey of Manufacturing Industries, Department of Statistics; Brazil: IBGE, FIPE; McKinsey
Global Institute

Exhibit 9

LABOR PRODUCTIVITY GROWTH IN CHINA


VS. KOREA 1996-2000
Productivity annual growth rate,
1996-2000
Korea
Percent

Labor Productivity Comparison


Value add/hour; index, Korea 1996-2000 = 100
Korea

China

80

5
Brown
Goods
39
Brown Goods China

40

20
White
Goods
White Goods China

0
1996

1997

1998

1999

30

2000

Source: China Electrical Industry yearbook; China Light Industry yearbook; China Statistical Yearbook; Korea National
Statistics Office

87

clusters. As a result, foreign companies find China more attractive than


other developing markets due to the relative ease of integrating its
operations in China.
A secondary factor that has been of negative influence is that of industry
structure and governance. Large amounts of capital have been made
available to state-owned enterprises (SOEs), distorting the markets
development. The large presence of SOEs in the sector has probably
decreased FDI marginally, as this has prevented international companies
who have entered from growing as large as they might have otherwise
done.
Initial sector conditions. Though competitive intensity in the sector has
generally been high, there were a number of gaps with best practice in
technology and productivity that created an opportunity for international
companies and has served to attract FDI into China.
FDI IMPACT ON HOST COUNTRY
Economic impact. Overall, China's productivity in the sector is 25 percent
that of Korean levels in 2000, and at-par with Mexico's. Non-FDI segments
display lower productivity than FDI segments, though the non-FDI segments are
also seeing very rapid productivity growth. Output growth is most rapid in the
FDI-segments, but this is likely due to industry-specific reasons (mobile
handsets are products that are relatively nascent). Employment is declining
rapidly in the non-FDI segments, while increasing in the FDI segment again
this may partially be due to industry-specific characteristics.
Sector productivity. Mobile handsets displayed the highest labor productivity
at 52 percent of Korea's level. This is also the sub-segment most dominated
by FDI. Though the non-FDI dominated sectors have lower productivity at
34 percent for brown goods and 19 percent for white goods these two
sectors are seeing productivity increase rapidly (exhibits 8 and 9).
Furthermore, a comparison of non-FDI companies compared to FDIcompanies in the broader electronics and electrical sector shows the latter
having 2.5 times the productivity of the former (Exhibit 10).
Sector output. All four sub-segments have grown but those with larger FDI
influence (mobile handset and PCs) have grown much more rapidly than
those with a smaller FDI-influence. Again, this is likely to be due to the
product mix, given the relatively nascent state of PC and handset products.
FDI companies produce 80 percent of exports, and exports represent around
40 percent of production. From this standpoint, FDI is quite an important
contributor to output (exhibits 11 and 12).
Sector employment. Again, the sectors with more FDI influence have seen
growing employment while the sectors with smaller FDI influence have
witnessed decreases in employment. This is due both to the large output
growth in the more nascent mobile handset and PC products, as well as the
ongoing restructuring of state owned enterprises (SOEs) in the white and
brown goods segments, where substantial overcapacity exists (Exhibit 13).
FDI can be considered to have made an important contribution to
employment.

88

Exhibit 10

LABOR PRODUCTIVITY BY OWNERSHIP STRUCTURE IN THE


ELECTRONICS INDUSTRY*
Index, China sector average = 100

155

2.5X

113
102

100
87
79
62

Foreign
Private co- Collective China
invested operative enterprise Average
enterprises enterprises

Private
Other
Stateenterprises enterprises owned
enterprise

* These figures are not directly comparable to productivity numbers on the prior page as they include a broader
industry description (electronics industry as a whole including industrial electronics)
Source: China Electrical Industry yearbook, McKinsey analysis

Exhibit 11

SALES GROWTH BY SUBSEGMENT

Sales
$ billions

CAGR
Percent

45.0
20.3

40.0
35.0
30.0
25.0
20.0

12.9

15.0

27.9

10.0

16.6

5.0
0.0
1996

42.5

97

98

99

2000

Source: China Electronic Industry Yearbook; China Light Industry Yearbook; McKinsey analysis

Overall
Brown goods
PCs
White goods
Mobile goods

89

Exhibit 12

EXPORT GROWTH BY SUBSEGMENT

Net exports
$ Billions

CAGR
Percent

30.0

Overall
Brown goods
PCs
White goods
Mobile goods

22.2

25.0
20.0
15.0

31.4

10.0

14.5

5.0
0.0
1996

22.8
18.3

97

98

99

2000
80% of sector
exports driven
by FDI

Source: UN PCTAS database

Exhibit 13

EMPLOYMENT IN CHINA CONSUMER ELECTRONICS SECTOR

Employment*
Thousands

CAGR
Percent

Overall
Brown goods
PCs
White goods
Mobile goods

Growth 2000-01
Percent

1200
1000
800

-2.4

3.2

-3.9

-2.4

-6.4
9.0
7.8

3.9
25.0
3.9

600
400
200
0
1996

97

98

99

00

2001

* Employment figures are reported figures from industry yearbooks


Source: China Light Industry Yearbook; China Electrical Industry Yearbook; UN PCTAS database; McKinsey Analysis

90

Exhibit 14
ESTIMATE

IMPORTANCE OF BUILDING UPSTREAM INDUSTRIES


TO HOST ECONOMY
Percent
Motorola has brought
its entire suply chain to
China, meaning much
more value add is captured
domestically than if it
imported all inputs

100
10
15
10

50

15

R&D

Supplier Manuindustries facturing

Sales and Distribumarkettion


ing

Total
value
add

Source: Company financials; Expert interviews; McKinsey analysis

Exhibit 15

PROFITABILITY IN CHINA
Emerging
technology

Evolving
technology

Mature
technology

ROIC 1998-2001*
Percent
25+%****

10

Mobile
phones***

PCs

Brown
Goods

White
Goods

* These are approximate ROIC estimates as detailed financials for fully accurate estimates not available
** Mobile phone based on TCL, Bird, Nokia, Samsung; PCs based on Legend, Founder, Tongfang, Great Wall,
Start; Brown Goods based on Konka, Skyworth, TCL, Hisense, Changhong, Panda, Xoceco; White Goods based
on Haier, Rongsheng, Changling, Meilin
*** Based on very rough estimates of gross and net profit margins and capital turns for 2001
**** Based on 2001 returns of ~25%
Source: Company financials; Analyst interviews; McKinsey analysis

91

Supplier spillovers. FDI companies have been crucial in creating supplier


industries in China. For example, Motorola created an end-to-end
production capability in China, which included setting up its supply chain in
China. Taiwan and Hong Kong investors were crucial to setting up some
elements of the PC supply chain in China. Supplier industries are an
important contributor of total value add in consumer electronics with over
50 percent of value added being contributed in this portion of the value
chain (exhibits 4 and 14).
Disaggregating the value chain in consumer electronics was also important
for establishing Chinese (non-FDI) finished goods suppliers in both PCs and
mobile handsets in China. The presence of component suppliers allowed for
the faster development of competitive local companies such as Legend in
PCs and Bird and TCL in mobile handsets8.
Distribution of FDI Impact
Benefits from FDI have been spread quite evenly across companies,
consumers, and workers in the Chinese consumer electronics sector. Non-FDI
companies seem to have benefited from the presence of FDI companies
through the transfer of technology. In some cases this was facilitated through
joint venture requirements and in others Chinese companies have emerged
with strong technology by a process of imitation.
Companies
FDI companies. FDI companies have had very mixed performance in
China they have in some cases been quite profitable and attained high
market share (e.g., Motorola and Nokia); in others they have retained
high profitability but have only gained a small market shares through
niche strategies (e.g., Dell in PCs) and in certain other cases they have
been unprofitable and have gained only a small market share (e.g.,
Whirlpool in white goods). Overall, the performance can be characterized
as mixed (Exhibit 15).
Non-FDI companies. Non-FDI companies have been successful in
maintaining market share and even gained market share from
FDI-companies in some segments.
Non-FDI companies are able to maintain strong market share positions in
the Chinese market through a combination of capabilities, governance
issues, and government policies. For example, non-FDI companies
dominate brown and white goods due to their stronger distribution
channels. SOE corporate governance also allows certain of these
companies to stay in business despite their low margins. In mobile
handsets, the technology favors FDI-companies while distribution
channels do not favor local players, as they generally cannot rely on
existing networks. In PCs, a long set of factors favor local companies,
including the presence of established distribution channels, government
purchases, low IP protection (which allows some non-FDI companies to
cut costs through installing pirated software). Certain trade regulations
8.

TCL has always been a standalone Chinese company (no foreign investors). Bird also originated
as a standalone Chinese company in 1992 (mobile handset production began in 1999) and
only recently entered into a joint venture with France's Sagem in November 2002 (Bird-Sagem
Electronics) in order to boost its production capacity.

92

Exhibit 16

MARKET SHARE DYNAMICS IN CHINESE CONSUMER


ELECTRONICS TOP 5 PLAYERS
Mobile handsets

PCs

1997

2002

1. Motorola
2. Nokia

39.9%
26.2%

3. Ericsson
4. Panasonic

21.9%
2.7%

5. NEC
6. Siemens

FDI player

1996

1. Motorola

23.8%

2. Nokia

17.1%

3. Bird*

9.6%
9.4%

4. TCL

1.2%
1.0%

5. Siemens

8.7%

6. Samsung

8.0%

7. Ericsson

3.0%

8. Philips

2.7%

9. Alcatel

2.5%

TVs

2001

1. IBM
2. Compaq
3. Legend
4. Hewlett-Packard
5. Great Wall
6. AST research
7. Acer
8. Digital Equipment
9. Tontru
10. Dell

10.2%
10.1%

1. Legend

9.2%
8.4%
3.3%
3.2%
3.0%
2.8%
1.6%
1.6%

26.9%

2. Founder
3. Tongfang

8.8%
8.1%

4. Start
5. IBM
6. Dell

4.8%
4.7%
4.5%
4.2%

7. Great Wall
8. Hisense

3.6%

9. HP

3.1%

10. TCL

4.6%

Refrigerators

1996

2001

1. Changhong
2. Panasonic
3. Konka
4. Beijing
5. TCL
6. Sony
7. Panda
8. Toshiba
9. Xoceco
10. Jinxing

20.5%
13.3%
12.2%
7.1%
6.2%
5.5%
4.6%
4.2%
2.7%
2.7%

1996

1. Changhong
2. TCL
3. Konka
4. Hisense
5. Skyworth
6. Haier
7. Sony
8. Panda
9. Toshiba

16.3%
12.8%
12.4%
9.3%
7.5%
6.5%
3.7%
3.5%
3.4%

10. Xoceco

3.2%

2001

1. Haier
2. Rongsheng
3. Meilin
4. Xinfei
5. Shangling
6. Changling
7. Hualing
8. Shuanglu
9. Bole
10. Wanbao

1. Haier
2. Rongsheng
3. Electrolux
4. Mellin
5. Siemens
6. Xinfel
7. Changling
8. Samsung
9. LG
10. Rongshida

29.0%
15.9%
13.2%
10.6%
9.3%
5.5%
3.2%
2.0%
2.0%
1.4%

25.3%
11.1%
10.7%
9.5%
9.0%
6.8%
5.9%
4.5%
3.7%
2.5%

* Bird began as a standalone Chinese company in 1992 (mobile handset production began in 1999), and only recently (November 2002)
entered a JV with Frances Sagem (Bird-Sagem Electronics) to boost production capacity
Source: Sino Market Research; BNP Paribus; Literature searches; McKinsey Global Institute

Exhibit 17

FACTORS EXPLAINING FDI PLAYERS vs. NON-FDI PLAYERS


++
MARKET SHARES IN CHINA
+
Operational factors
Marketing
branding

Distribution

Technology

Willingness to
accept
low
margin

Non-FDI player favored


Not a factor
FDI player favored

External factors
Government Corporate
IP
financial
governJV regula- protec- Trade Income
support
ance
tions
tion
barriers levels

Mobile
handset

PCs

Brown
goods

++

++

++

++

White
goods

++

++

Both capabilities and government


policies aimed at creating/sustaining
local champions has led to market
share dominance in 3 of 4 segments
for Chinese players

Source: McKinsey Global Institute

93

have also reinforced this advantage, in that the government started to


enforce import tariffs in the late 1990s, which hurt foreign companies
whose products were being imported through the gray market
(exhibits 16 and 17).
Domestic companies have gained technology from foreign companies in
many cases. This has happened both through joint ventures as the
government requires this of foreign companies in many cases in
exchange for their entry into the local market and through collaboration
with FDI companies (Exhibit 18).
China is the world's largest mobile handset market. FDI-companies such
as Motorola and Nokia had dominated the market between 1996-2000.
Companies such as TCL have since gained share rapidly. Such local
companies have moved from almost zero market share in 1999 to a
reported share of up to 50 percent of the total market in 2003. The
sector demonstrates the Chinese companies' strengths in dominating
distribution and being able to acquire technology.
Employment
Employment level. As detailed previously, employment grew in the FDIinfluenced sectors (because of the product mix and export production)
and declined in the non-FDI dominated sectors. SOE restructuring was
the key reason for this employment decline.
Wages. We have no evidence on differential in wages in this case.
Consumers
Prices. Prices have declined steadily in this area especially in the nonFDI sectors. For example, in televisions, a price war raged through the
early 2000s. This price war was caused by overcapacity for the non-FDI
companies, who aggressively cut prices (Exhibit 19). Prices for goods are
generally cheaper or on par with the ultra competitive U.S. market. NonFDI brand TVs sold for 15 percent below U.S. retail prices, while foreign
brand TVs were significantly more expensive. Foreign branded PCs were
15 percent below U.S. retail prices, while domestic brand PCs were even
lower priced. Only in refrigerators, were Chinese prices higher. Here
Chinese domestic brands are 17 percent more expensive than U.S. prices
and foreign brands 35 percent more expensive (Exhibit 20).
For mobile handsets, price competition has not been quite as aggressive
to date, as companies compete on brand and design, though price
competition is now picking up. Overall, the household appliance deflator
our closest available approximation for consumer electronics prices in
China has declined by an average of 5 percent per annum between
1996-2001.
Product variety and quality. FDI companies have clearly added to product
variety both through higher technology products and design
improvements. For example, in refrigerators Electrolux has a product
tailored to the Chinese market that integrates a picture frame designed
to hold a wedding photo into the front of the unit. It recognizes that
Chinese families often receive a refrigerator as a wedding gift and keep it
in the living room of their home. Other companies, such as Sony, have
focused on high-end products, such as high-picture quality flat screen
TVs.

94

Exhibit 18

FDI/FOREIGN COLLOBORATION BETWEEN CHINESE COMPANIES AND


MNCs
JVs
Great Wall

Capitel

JVs with IBM

Eastcom

JV in mobile

starting in 1994
include
Personal
computers
Printed circuit
boards
Storage media

JV in mobile

phones with
Nokia starts in
1995

phones with
Motorola starts in
1996
Foreign investment
and collaboration
have been driving
forces to China
technology development for local
Chinese companies

Collaboration
Haier
1984

1994

Haier imports refrigerator production line


from German LiebherrHaushaltsgerate

Cooperate with
Mitsubishi to
manufacture airconditioner

1999
Agreement signed
between Haier and
Lucent to cooperate
in GSM technology

2001
Haier and Ericsson
jointly develop "Blue
tooth technology

Source: Company reports; McKinsey analysis

Exhibit 19

CHINAS WHITE GOODS AND BROWN GOODS DEMAND AND SUPPLY

Excess supply

Slowing demand
Sales growth CAGR;
percent

Over capacity, 2000; percent

1995-97
1997-99

10
87%

7
16
11
13
8

Rapid price
decrease
erodes profit
margin

45

39

12
30

Intense competition

Multinationals such as Whirlpool, LG, Matsushita,


Siemens have entered the market

Local SMEs are emerging, targeting low-end market


Source: China Statistical Yearbook; Report from China Light Industry Information Center; McKinsey analysis

95

Exhibit 20

CONSUMER ELECTRONICS RETAIL PRICING IN CHINA


VS. U.S.

U.S.
China domestic brand
China foreign brand

Index, U.S. = 100


157
135
117
100

100

100

85

85

n/a*
TVS price per inch

Refrigerators
price per liter
capacity

* Difficult to find exactly comparable U.S. PCs to domestic brand Chinese PCs
Source: Store visits; retailer Web sites

PCs similar
desktop PCs

96

Exhibit 21

EXPORTS IN CHINESE CONSUMER ELECTRONICS SECTOR


Top foreign invested enterprise consumer electronics
exporters 2000
$ Billions
Company

Sub-segment

Exports

Samsung

White, Brown, Mobile

1.5

Nokia

Mobile

1.1

Motorola

Mobile

1.1

Seagate

PCs

1.1

Epson

PCs

1.0

Philips

Brown

0.6

Top Victory

PCs (monitors)

0.6

Flextronics

PCs

0.5

LG

White, Brown, Mobile

0.5

PCs (monitors)

0.5

10 Ximmao Technology/
Elite Group

Source: Chinese National Statistics

Foreign investment
enterprises
responsible for 80%
of industry exports
These companies
provide China access
to new markets that it
would probably not
export to otherwise

97

Government. Data on the consumer electronics sector's contribution to


government tax receipts is not available. Given that many companies'
receive significant tax breaks in SEZs, the tax impact here is likely to be
muted. Foreign companies income taxes on expatriate salaries represent a
somewhat significant source of revenue for the Chinese government.
Overall, the government probably benefits a small amount from the
presence of FDI companies.
HOW FDI HAS ACHIEVED IMPACT
Operational factors
One key impact of FDI has been to bring China new technologies across all
sub-segments; this has helped improve the product mix (impacting sales
and productivity) while also allowing export growth.
Direct improvements in productivity have occurred either through the higher
productivity of foreign plants (e.g., PC production at Dell) or through
"strategic OEMing", where foreign OEMs take a joint venture in Chinese
operations and then improve productivity of its manufacturing operations in
order to reduce cost (as seen in brown and white goods production).
FDI companies are responsible for 80 percent of China's consumer
electronics exports, a unique benefit given that Chinese companies do not
have established brand and distribution in foreign markets (Exhibit 21).
Industry dynamics. Local companies already compete strongly against each
other. FDI simply added to this level of competition. In fact, the non-FDI
dominated sectors display the highest level of competition and the
FDI-dominated sector (mobile handsets) has displayed a somewhat lower level
of competition. As non-FDI companies have entered the handset market
competition in this sub-segment has increased (Exhibit 16).
EXTERNAL FACTORS THAT AFFECTED THE IMPACT OF FDI
Overall, external factors have had both positive and negative effects on the impact
of FDI. On the positive side, China's market size and growing supplier industries
allowed companies to achieve higher impact in China through economies of scale
and better integration. However, state-ownership and weak IP protection have
impacted FDI's performance negatively in some sub-segments.
Country specific factors
Positive impact
Market size and attractiveness. China's consumer electronics market is
large. This has been spurred on by high competition, low taxes, and
stable and high GDP growth. This large market allows for the building of
scale in both supplier and final goods industries, which helped improve
the efficiency of foreign direct investment.
Infrastructure. Good infrastructure is especially important in attracting
efficiency-seeking FDI. This was provided in business friendly SEZs
areas provided with good access to important inputs, such as electricity

98

Exhibit 22

CHINESE CONSUMER ELECTRONICS COMPANIES PROFITABILITY VS.


SHARE OWNERSHIP
Corporate governance
Number of
companies* =

State shares

Legal person

29

30

29

33

42

37

36

57

Free float**
Higher profitability
(ROIC>10%)

Moderate
profitability
(10%>
ROIC>0%)

Low profitability
(0%>ROIC)

* Higher profitability companies include Legend, Haier, Tongfang, Skyworth, Founder, Midea and Gree; Moderate
profitability companies include TCL, Konka, HiSense, Changhong, Little Swan and Amoisonic; Low profitability
companies include Great Wall, Rongsheng, Panda, Start, Xoceco, Changling, Meilin and Duckling
** Shares of a public company that are freely available to the investing public
Source: Company financials; McKinsey Analysis

99

and telephone systems, and providing eased entry with simplified


legislative requirements. This enhances China's competitiveness by
reducing time to market.
Supplier industry crowding-in. The growing supplier industries have made
China increasingly attractive to investment and helps reduce costs
through better integration. As the supplier base grows, this serves
attracts further finished goods and supplier industry investment
(economies of scale and scope) creating a virtuous cycle.
Neutral impact
Incentives. "Sweeteners" offered in the form of tax breaks did little to
improve competitiveness or increase the impact of FDI. Even without
these, China was already attractive to market-seeking and efficiencyseeking FDI.
Joint venture requirements and the local champions policy. China put in
place a joint venture policy in mobile phones9 to encourage technology
transfer and the creation of "local champions". This policy appears to
have had little impact on the level of FDI, though local champions (e.g.,
TCL) have been created.
Trade barriers. In the late 1990s the Chinese government cracked down
on the grey market (in which foreign branded PCs, not manufactured
locally, were imported into China). This market was avoiding tariffs that
fluctuated between 10-20 percent. However, the enforcement of the
trade tariff did not affect international companies manufacturing in China
using FDI, only those who were seeking to export to China. Today China
does not have an import tariff on PCs.
Negative impact
Corporate governance regulations and state ownership. Shareholder
governance is weak in China. Companies are subject to little shareholder
discipline, which means that some of them survive with low and even
negative earnings for several years or more. The impact of this on
Chinese companies is evidenced by the fact that shares in the Chinese B
shares market (the foreign investors market) trade at a fraction of the
level of those in the Chinese A market (the local investor market). This
distorts the market, reducing the impact of potential productivity gains
(Exhibit 22).
Intellectual property protection. The lack of IP protection reduces the
potential competition of FDI companies in the PC segment. For instance,
certain local companies install pirated versions of Windows on their PCs,
giving them a cost/price advantage.
Sector initial conditions
Competitive intensity. The high competitive intensity of the Chinese market
has increased the impact of FDI, as non-FDI companies have quickly
imitated new products and adaptations as brought to market by foreign
companies. For example, in mobile handsets, local companies like TCL have
launched designs based on those currently available from international
companies in order to gain share.
9.

As was previously the case in computers, though the regulations have recently been liberalized.

100

Closing the gap with best practice. As mentioned earlier, many non-FDI
SOEs especially in brown and white goods operate at low levels of
productivity. Through strategic OEMing, FDI has improved productivity in
these operations. Furthermore, FDI companies have 2.5 times the
productivity of non-FDI companies, and have thus improved the overall
productivity of the sector as they have gained market share.
SUMMARY OF FDI IMPACT
FDI impact has been very positive in China, bringing new technologies, more
efficient processes, and building a more robust supplier base. In particular, this
increased supplier base has created crowding in effects in China. Its access to
export channels via established brand and sales channels have played a crucial
role in driving Chinese exports. FDI has only marginally added to competitive
intensity (through new designs and high-end niche strategies), as non-FDI players
fuel competitive intensity in China. Chinese consumers have benefited most
dramatically with a wide-variety of competitively priced goods available in China.
Furthermore, FDI has helped dampen effects on Chinese workers, as growth in
export-oriented employment has helped absorb job loss from SOE restructuring.

101

Exhibit 23

CHINA CONSUMER ELECTRONICS SUMMARY

A domestic market with extremely high potential size/growth


drives market seeking FDI to China. Meanwhile, low factor
costs and culture/ethnic ties to Taiwan and Hong Kong
investors drive large amount of efficiency seeking FDI to
China

Chinese companies drive high-competitive intensity in the


local market due to the predominance of state ownership
which creates overcapacity and drives aggressive pricing by
some players

FDI adds to competitiveness by bringing new products,


which Chinese players quickly imitate

SOE players restructure/layoff workers as government


pursues marketization program

Foreign players help drive strong export growth and


somewhat increase productivity through higher value added
products/processes. Employment growing in export oriented
sectors

FDI impact has been very positive in China, bringing


new technologies, more efficient processes, and
building a more robust supplier base. Chinese consumers
have benefited most. In addition to having lower priced
goods, FDI has helped absorb job loss from SOE
restructuring

External
factors
1
2

FDI

Industry
dynamics
4
Operational
factors

6
Sector
performance

Exhibit 24

CHINA CONSUMER ELECTRONICS FDI OVERVIEW

Total FDI inflow (1996-2001)


Annual average
Annual average as a share of sector value added
Annual average per sector employee
Annual average as a share of GDP

$23 billion
$3.8 billion
29% (lag effect)
$4,400
0.33%

Entry motive (percent of total)


Market seeking
Efficiency seeking

65%
35%

Entry mode (percent of total)


Acquisitions

0%

JVs

60%

Greenfield

40%

102

Exhibit 25

CHINA CONSUMER ELECTRONICS FDI IMPACT


IN HOST COUNTRY

Economic impact

Sector productivity

Early FDI
(1980-1995)

Mature FDI
(1996-2001)

FDI
impact

n/a

++

(CAGR)

++
+

[]

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

Evidence

Mobile phones sector (FDI dominated)


highest productivity sector

Productivity growth very steep across


all segments

FDI players 2.5X higher productivity


than non-FDI players

Sector output

n/a

++

++

(CAGR)

Sector employment

domestic market output, but FDI


enterprises account for 80+% of
exports (which is 40+% of total output)
n/a

(CAGR)

Suppliers

Non-FDI enterprises still dominate

Employment growing in PCs (due to


exports) and handsets (FDI-dominated);
in white and brown goods employment
(non-FDI dominated) employment is
shrinking

n/a

++

++

Significant supplier base building in


PC/handset sector by FDI players; also
some in brown and white goods

Impact on

n/a

++

competitive
intensity

Many FDI players present in China, add


to competition through higher technology
products and niche strategies; Chinese
players are still drivers of competition
overall

Exhibit 26

CHINA CONSUMER ELECTRONICS FDI IMPACT


IN HOST COUNTRY (CONTINUED)

Distributional impact

Early FDI
(1980-1995)

Mature FDI
(1996-2001)

FDI
impact

n/a

+/

+/

n/a

++
+

[]

Evidence

Companies
MNEs
Domestic
companies

Mixed profitability for FDI players with


mobile phone players performing well,
others performing poorly

Local companies have gained through


foreign presence by imitating
technology. This has in some cases
been facilitated by JV requirements
Share losses to MNCs only in some
minor subsegments (e.g. refrigerators)

Employees
Level of
employment
(CAGR)
Wages

n/a

See prior page for evidence

n/a

[O]

[O]

No evidence on changes in wages

n/a
n/a

+
+

O
+

Local players drive low prices in CE


FDI brings high-technology, specialized

Consumers
Prices
Selection

goods across sub-sectors (e.g. high


end TVs, mobile phones)

Government
Taxes

n/a

[+]

[+]

Tax burden very low on FDI players as


well as locals; however, should be
marginal gain in taxes due to some
taxes on export-oriented FDI

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

103

Exhibit 27
High due to FDI
High not due to FDI

CHINA CONSUMER ELECTRONICS


COMPETITIVE INTENSITY
Prior to focus
period (19801995)
Pressure on
profitability

n/a

New entrants

n/a

Weak player exits

n/a

Pressure on prices

n/a

Changing market
shares

n/a

Pressure on product
quality/variety

n/a

Pressure from
upstream/downstream industries

n/a

Overall

n/a

End of focus
period (19962001)

Low

Evidence

Rationale for FDI contribution

Profitability low in all

FDI players are not drivers

subsegments except
mobile phones

of low profits; in fact, are


dominant in highest profit
segment

New entrants in all

FDI players in all segments,

segments

as well as Chinese

Some weak

SOE restructuring drives

player exits

exits, with government


pushes SOEs towards
more private ownership

Price drops have been

Over-capacity in SOEs

significant in CE over
the listed time period
(25-50+%)

drives pricing

Market share shifts

Driven by SOEs in all

pronounced across all


4 segments

except white goods

New products on market

MNCs generally bring

such as mobile handsets;


high-end brown and
white goods

these products and


Chinese players imitate

Competitive intensity is

Overcapacity/aggressive

high as evidenced by low


profitability and declining
prices

SOEs generally drive


competition

Exhibit 28

CHINA CONSUMER ELECTRONICS


EXTERNAL FACTORS EFFECT ON FDI
Impact on
level of FDI

Comments

++ Highly positive

Impact
on per
$ impact

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

Comments

Level of FDI*
Global
factors

Global industry
discontinuity
Relative position
Sector Market size potential
Prox. to large market
Labor costs
Language/culture/time zone

(' in) Macro factors


Country stability

Countryspecific
factors

Continued value chain

disaggregation opens opportunity


for China
++
O
++
+

Product market regulations


Trade regulations
Preferential export access
Recent opening to FDI
Remaining FDI regulation
Government incentives

O
+
O
O
O

TRIMs
Corporate Governance

Taxes/other

Capital deficiencies

4th largest CE market in world


Important for efficiency seekers
Taiwanese/Hong Kongese key

investors; Location good for E. Asia,


where CE center of gravity resides
Stable currency and country
environment attracts investors

WTO entry
Incentives present, but not crucial to FDI
decision for most

Strong competition from unprofitable

++
O
O
O
O

Allows for building of scale


Increases export competitiveness

O
O
O
O
O
O

SOEs may have reduced FDI, though


most foreign players present

Some Chinese players survive with low


profitability due to weak shareholder
protection, state ownership

Weak IP protection, government purchases


boost local players in PCs

Although capital may have been scarce for

private entrepreneurs it was more than


compensated for by capital available to
SOEs
Labor market deficiencies
Informality
Supplier base/infrastructure

O
O
++

Supplier industry strength becoming

O
O
++

powerful attractor of additional FDI


Sector
initial
conditions

Competitive intensity

Gap to best practice

O(H)

+(M)

Competitive intensity was already high

in China, but most players came anyway


due to size of opportunity
Chance to bring higher value add
products attracted foreign players

Increases efficiency and opportunity for FDIdriven exports

+ (H)

High competitive intensity increases the speed

+ (M)

Low initial productivity levels has allowed for

of diffusion of new technologies

more long-hanging productivity improvement


opportunities to be captured by FDI

104

Exhibit 29

CHINA CONSUMER ELECTRONICS


FDI IMPACT SUMMARY

[ ] Estimate

++ Highly positive

Negative

+ Positive

Highly negative

O Neutral

( ) Initial conditions

External Factor impact on


FDI impact on host country
Level of FDI relative to sector*

29%

Level of FDI
Level of FDI** relative to GDP

Per $ impact
of FDI

0.33

Global industry
discontinuity

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

++
O
++
+

++
O
O
O

Macro factors
Country stability

Product market regulations


Import barriers
Preferential export access
Recent opening to FDI
Remaining FDI restriction
Government incentives
TRIMs
Corporate governance
Taxes/other

O
+
O
O
O
O

O
O
O
O
O
O

Capital markets

Labor markets

[O]

Informality

++

++

Prices

Supplier base/
infrastructure

(Selection)

+
Competitive intensity

O (H)

+ (H)

Gap to best practice

+ (M)

+ (M)

Economic impact

Global factors

Sector productivity

Sector output

++

Sector employment

Suppliers

++

Impact on
competitive intensity

Distributional impact
Countryspecific factors

Companies
MNEs
Domestic

+/
+

Employees
Level
Wages

Consumers

Government
Taxes

[+]

* Average annual FDI/sector value added


** Average (sector FDI inflow/total GDP) in key era analyzed

Sector initial
conditions

India Consumer
Electronics Summary
EXECUTIVE SUMMARY
In the early 1990s, the Indian government opened up its previously protected US
$8 billion domestic consumer electronics market to international investment.
Since then, India has received around US $300 million in FDI per year. Though
this represents 20 percent of the total FDI to India during this period, it is only half
the level of annual investment achieved in Mexico and Brazil and just 8 percent
of the investment in China. This inflow of FDI has been made in large to overcome
import tariffs that range from 30 to 50 percent of product value.
Overall, the impact of FDI in India has been positive. The sector's output and
productivity have increased as a result of the implementation of improved
manufacturing techniques in the companies acquired by international companies
and the higher productivity levels of newly constructed multinational company
plants. Consumers have received the greatest benefits from the entry of
international investment. Prices have declined as a result of increased
competition and the product selection has increased. The spillover effects upon
suppliers have been limited as most investment has been in assembly operations
and these have relied on imported inputs. Domestic incumbent companies, with
lower productivity levels, have been impacted negatively by the increased
competition. Their market share and employment levels have both declined.
However, the remaining constraints on both foreign as well as domestic players
have severely increased the production costs and limited productivity growth, thus
keeping the impact of FDI below its potential. High policy barriers high indirect
taxes, high and poorly enforced sales taxes causing informality, and distorting
state-level tax incentives leading to fragmented and sub-scale production keep
prices of domestic production above world prices. As a result, Indian consumers
continue to face 30 percent higher prices than Chinese consumers, and the
goods have a significantly lower penetration rate, including refrigerators and
mobile phones.
OVERVIEW
Sector overview
The size of the Indian consumer electronics sector was approximately $8 billion
in size in 2001. Exports are not a major factor in Indian consumer electronics,
generating a mere $100 million in 1999.10
Brown goods are the biggest sub-segment in India, though mobile handsets
are the fastest growing portion of the market overall, with an annual growth
rate of over 80 percent from 1999-2001 (Exhibit 1).
Finished goods exports are declining, having halved in value between 1996
and 1999. Imports have tripled over the same time period, rising from
$235 million to $715 million (Exhibit 2).

10. 2001 is the last year for which the U.N. publishes data for India.

105

106

Exhibit 1

INDIA CONSUMER ELECTRONICS MARKET SIZE BY SEGMENT


$ Billions

CAGR
Percent
7.9

15.1

1.2

83.2

2.2

17.9

2.6

2.6

1.1

13.3

4.7

0.6

Mobile phone

5.9
0.4

PCs

1.5

Brown goods

2.5

White goods

1.5

1.7

1.9

1999

2000

2001

1.8

Source: MAIT; ELCINA; literature search; McKinsey Global Institute

Exhibit 2

INDIA CONSUMER ELECTRONICS FINISHED GOODS TRADE*


$ Millions
Total India exports, 2000 = $44 billion
Consumer electronics exports
CAGR -25%

261

235

0.02%

1996

1997

105

109

1998

1999

Consumer electronics imports


CAGR 48%

715
474

547

235

* Indias export data only currently available up to 1999


Source: UN PCTAS database

1996

1997

1998

1999

107

FDI Overview
FDI levels
FDI in the sector has averaged around $300 million per year between
1996-2001. Though this is small compared with Mexico, China, and
even Brazil, at 20 percent of the total annual FDI to India, it represents
a significant share of this total (Exhibit 3).
International companies have entered India both through joint ventures
and through standalone ventures, the majority having followed the latter
course (Exhibit 4).
The pace of foreign direct investment has increased since the mid1990s, following India's adoption of more liberal policies towards FDI. The
entry of LG and Samsung in the mid-1990s was especially notable as
their entry markedly increased the level of competition in the market
(exhibits 5 and 6).
FDI impact. Due to the limited availability of data, it is not possible to make
thorough comparison of the pre-FDI period (pre-1994) with the maturing FDI
period (1994 to present). We have therefore assessed the impact of FDI
using qualitative information gained from interviews and comparisons with
other countries.
External factors driving the level of FDI. Probably the three factors most
important in attracting FDI to India were, the potential market size (though
much of this potential has yet to be realized), continuing import barriers (which
made it impossible to participate in the local market without possessing local
operations), and the liberalization of FDI-entry in the early 1990s. However,
several factors serve to continue to repel further FDI particularly, efficiencyseeking FDI. These factors include high indirect taxes, which have suppressed
domestic demand, labor market inflexibilities, and a very poor export
infrastructure. Overall, India's level of FDI is probably well below what it could
be potentially due to these negative factors (Exhibit 7).
Factors that have encouraged FDI
Market potential. Given its more than 1 billion population, India has a
very large market potential for consumer electronics. Though currently
this market is only $8 billion, its full potential could be double this size or
more; this would represent a larger market than Brazil and Mexico
combined. Prior to FDI liberalization, the Indian market lacked products
that other developing countries already have access to. For example, until
recently black and white TVs played a much larger role in the Indian
market than they did in other comparable markets. FDI has helped
advance the market towards flat picture tube products of the 20-21" size
range.
Policy liberalization. The Indian government began its program of market
liberalization in the early 1990s. Players such as LG, Samsung, and
Matsushita, among others, entered the Indian market in the mid-to-late
1990s.
Import barriers. Rates of protection in India average 30-40 percent for
consumer electronics goods like TVs, PCs, and refrigerators. Given that
there are local players already participating in each of these segments
and that Indian consumers are extremely price sensitive, it is imperative

108

Exhibit 3

FDI IN INDIA CONSUMER ELECTRONICS SECTOR*


$ Millions

844

519
334
183

Total FDI to India


Percent

271

228

1996

1997

1998

1999

2000

2001

13

11

29

16

17

27

* Our FDI definition includes Domestic Appliances, Electronics and Electrical equipment and Computer
Source: RBI India annual reports

Exhibit 4

PLAYERS PRODUCING IN INDIAS OWNERSHIP STRUCTURES


Foreign-owned

None

JV

Indian-owned

None

None

Mobile
phones****

Hewlett-Packard India

PCs and
components

Phillips India
LG Electronics India
Samsung India

Matsushita Television and

Brown
goods

White
goods

Whirlpool India
LG Electronics India
Samsung India

Amtrex Hitachi
Electrolux Kelvinator

Audio India

* Previously joint ventured with HP (until 1997)


** Had alliance with GE, terminated in 2001
*** Contract manufacturers refrigerators for LG and Samsung
**** All mobile handsets currently imported; no production in India
Source: Literature search; company shareholding information

Wipro
HCL Info Systems*
CMC
Vintron

BPL
Mirc Electronics
Videocon International

Symphony Comfort Systems


Videocon Appliances
Godrej Appliances***
Voltas**

109

Exhibit 5

MULTINATONAL COMPANY ENTRY IN INDIA CONSUMER ELECTRONICS


Entry date

Revenue, 2001
$ Millions

Key products

Phillips

1930

315

Lamps
Audio equipment

Hewlett-Packard

1976

317

PCs and servers

LG

1994

362

Televisions
Refrigerators
Washing machines
Air conditioners
Monitors

Samsung

1995

Televisions
Refrigerators
Microwave ovens
Air conditioners
VCD/DVD players

Electrolux

1995

85

Whirlpool

1995

228

Matsushita

1996

36

Televisions

Hitachi

1998

74

Room air

Refrigerators
Refrigerators
Washing machines

conditioners
Source: Company financials; company websites

Exhibit 6

MARKET SHARE BY CONSUMER ELECTRONICS SEGMENT IN INDIA


Percent

FDI-company

Mobile handsets 2001

PCs 2001

Others
Sony-Ericsson
6

Samsung 8
47 Nokia

Panasonic 9
Motorola

35

Unbranded +
46
branded
assembled

11

19

12

Indian brand (Wipro = 9%),


HCL = 8%)

Siemens

TVS 2001

Others

MNC
brands
(HP = 11%)

Refrigerators 2001

23

Videocon
International

Others
18

32

32 Whirlpool

Voltas 8
15 BPL

Philips
Samsung
India

10
LG
Mirc
Electronics
Electronics
9

Source: IDC; Center for Monitoring the Indian Economy

Electrolux 13
Kelvinator

14

LG
Electronics

15

Godrej
Appliances

110

Exhibit 7

EXTERNAL FACTORS THAT HINDER INDIA CONSUMER


ELECTRONICS PERFORMANCE

External factor

5
Low scale/
undeveloped
supplier industries

Sales tax
regulations
6

Less
exports

Competition
reducing
tariffs on
final goods

Low
productivity

4
Poor export
infrastructure/
incentives

Restructure
labor laws

Destructive
cycle

Less FDI
attractiveness

2
Demand for
low-value add
products

Tariffs on inputs
and capital
equipment

3
High
prices

Low
demand

Inefficient
retail

High indirect
taxes

Grey
market

Source: McKinsey Global Institute

Exhibit 8

TARIFFS ON FINAL GOODS AND EFFECT ON COMPETITION


Average tariff/effective
rate of protection on
final goods
Percent

TV example Colour TV price breakdown


Index, International Best Practice = 100
Includes raw
material, conversion
costs and margin

130
Mobile*
phones

14

The protection offered by


import duties on domestic
players finds to mask
inefficiency

100

39

PCs

9-12
Refrigerators

Retail
price
TVs

30

Source: McKinsey CII report

8-10

30

39
International
best
practice
price

Import duty Import duty Higher


on finished on raw
margin
good
material

8-13
Inefficiency
in the
process

111

to set up operations in India to play in the consumer electronics market


(exhibits 8 and 9).
Competitive intensity. Players in the market earned 8 percent net
margins on sales before the entry of the Korean companies, making the
market attractive to FDI.
Factors that have discouraged FDI
High indirect taxes. India has high indirect taxes on goods over 30
percent in some cases. These raise the final prices of goods and
suppresses market demand. This not only reduces market-seeking FDI
but reduces India's attractiveness to efficiency-seeking FDI (Exhibit 10).
Labor market deficiencies. Strict labor laws prevent Indian companies
from retrenching labor easily. This is another factor that makes India a far
less attractive location for efficiency-seeking FDI than China (Exhibit 11).
Infrastructure. India's export infrastructure is far less advanced than
China's. For example, exporting goods from India to the U.S. takes up to
three weeks longer than it does to export goods from China (Exhibit 12).
Also, the electricity infrastructure is unreliable and this constrains growth.
FDI IMPACT ON INDIA
Economic impact
Sector productivity. Labor productivity of consumer electronics in India is
about half that of China, and only 13 percent of Korean levels. Some of the
productivity disadvantage vis--vis China and Mexico can be traced to the
production mix. The product mix in India included more low-end goods, such
as smaller and black and white televisions. However, India does not
manufacture export-oriented goods (as does China) which are often more
labor intensive, so this helps counteract the effects of product mix effect vis-vis China. Interview evidence shows that there are also physical
productivity differences of between 10-50 percent between India and China
plants with similar goods (Exhibit 13).
Interview evidence indicates that FDI has had a positive impact on
productivity, both through direct effects and increased competition. For
example, one FDI player improved the productivity of a contract
manufacturer by nearly four times by implementing improved manufacturing
techniques. Furthermore, because of heightened competition, players such
as Whirlpool and Philips have recently reduced their workforces in India. The
catalyst has been the heightened competition resulting from the entry of the
Korean players.
Sector output
Domestic demand. Domestic demand continued to grow at an average
of 15 percent per annum from 1999-2001, with very high growth in
mobile handsets, high growth in PCs and white goods, and flat sales in
brown goods. Given FDI's contribution to decreasing prices, which led to
market growth in the brown and white goods segments, we attribute
some of the sector output growth in these segments to FDI (Exhibit 1).
Export performance. India's level of exports is meager. It is a net importer
of finished goods in consumer electronics (Exhibit 2). FDI has not

112

Exhibit 9

TARIFFS ON INPUTS AND EFFECT ON FINAL GOOD COST

India
China

Import duty on
raw material
Percent
30

CPT

Increase in final
good cost
Percent

30

+10% to TV cost

21

+1% to TV cost
+ 3% to
refrigerators

11

+3% to TV
refrigerators

25

+2% for assembly


+4% for capital
intensive inputs

60

1,010

30

805

10

37

15

Aluminum

Price
difference
Percent

42

10

Plastic

Capital
equipment

Price
Dollar per unit or ton

33
25

N/A

Source: McKinsey CII report; McKinsey Global Institute

Exhibit 10

INDIRECT TAXES, PRICES AND THE GREY MARKET IN INDIA

India
China

Indirect Taxes in India


Percent
Mobile*
phones

Retail prices
USD per unit

604

24

349

357

291

240

270
180

24

PCs

33

Refrigerators

TVs

Difference
Percent

Mobile phones
~17

PCs
26

Refrigerators
33

TVs
33

Mobile phone grey market**


Percent
90
50

24

China
Percent
Most goods

816

14

Maharashtra
Sales tax

9*

Punjab
4

* Includes 4% sales tax and 5% octroi


** Grey markets refer to the illicit, but technically legal, activities that are not reported to the tax authorities and the income from
which goes untaxed and unreported.
Source: National statistics; literature search; McKinsey Global Institute

113

Exhibit 11

LABOR LAWS INDIA VS. CHINA

Barriers to
retrenchment

China

India

Chinese enterprises given

Government approval required to close a


company

autonomy to retrench workers


with one month notice period

Retrenchment of workers for poor performance


leads to litigation or trouble with labour unions

Union activity largely subdued


Labour
unions

large companies forcing fragmentation of


production capacity

Enterprises granted autonomy


Wage
structure

to establish internal wage


systems (e.g., can link wages to
productivity or output)

Contract workers permitted in all


Nature of
employment

Power of labour unions hinders functioning of

industries

No lifetime employment even in

Productivity linked wages difficult to implement


in large enterprises due to power of unions

Wages partly linked to output in small


enterprises

Labour can be hired on contract only for a


maximum of 11 months beyond which they
have to be made permanent employees

SOEs in China

Source: China Hand EIU

Exhibit 12

PROCESSING TIMES FOR EXPORTS INDIA VS. CHINA

China

Days

India

Average lead
time for the U.S.
Number of days
Processing time at
customs for imports

2.0
10.0

Time at customs
for exports

0.5

Loading/unloading
time at ports

1.0

Total time
(for garment
involving import
and re-export)

China

55-60

5.0

5.0-10.0

India

70-75

4.0-5.0
20.0-25.0

The door-to-door shipping time from India is about 5 weeks.


For China it could be 3-4 weeks. This 1 week can be
very crucial for us, given shortening fashion cycles
Apparel buyer
Source: Interviews; CII-Worldbank study

114

Exhibit 13

LABOR PRODUCTIVITY COMPARISON BY SEGMENT**


Index*, Korea = 100
Mobile handset assembly**
100
52

n/a

n/a
In
di
a

C
h
in
a

n/a
M
ex
ic
o

B
ra
zi
l

M
al
ay
si
a

K
or
e
a

n/a

PCs and components assembly


Labor productivity (excl. mobile phones)
Value add/FTE
100
25

24

C
h
in
a

28

24

11
In
di
a

M
ex
ic
o

B
ra
zi
l

38

29

M
al
ay
si
a

34

K
or
e
a

40

100

13

In
di
a

C
h
in
a

B
ra
zi
l

55

34

35

In
di
a

61

M
al
ay
si
a

K
or
e
a

47

M
ex
ic
o

na

ex
ic

100

Ch
i

al
ay
sia
M

Br
az
i

Ko
re
a

Brown goods assembly

White Goods
100
17

12
In
di
a

C
h
in
a

19
M
ex
ic
o

B
ra
zi
l

34

M
al
ay
si
a

K
or
e
a

35

* Indexed to Korea = 100: Base measurement = RMB/worker/hour


** Koreas mobile handset industry definitions includes other wireless devices such as wireless broadcast transmitters and wireless closed
circuit cameras; Indias numbers are calculated using data of listed companies (largest); they may be biased upward because of this
Source: China: China Electrical Industry Yearbook, China Light Industry Yearbook; Korea: National Statistical Office, Electrical Industry
Association of Korea; Malaysia: Annual Survey of Manufacturing Industries, Department of Statistics; Brazil: IBGE, FIPE; McKinsey
Global Institute

Exhibit 14

INDIA CONSUMER ELECTRONICS EMPLOYMENT


Output per capita in
consumer
electronics
Dollars/inhabitant

Mobile
phones*

India
China

Employment per million


workers in consumer
electronics

0
7.6

79

In domestic
market
underpenetration and
low exports
means that
India has
failed to
create much
needed
employment

39

0.9

PCs
15.0

Brown
goods

White
goods

286
60

2.4
13.5
1.4

265
78

15.4

* All mobile handset currently imported, no production in India


Source: McKinsey Global Institute

661

115

improved India's export performance in the time period under review,


though our interviews indicate that Korean players might look to export
certain products from India in the future (perhaps as a second source to
China).
Sector employment. No data is available on sector level employment for
Indian consumer electronics. Because there is a combination of output
growth and productivity improvement over the time period, employment
change is ambiguous. In terms of employment level, India has certainly
under-performed vis--vis China, creating only 15 percent as many jobs per
million workers, due to both lower domestic demand as well as exports
(Exhibit 14).
Supplier spillovers. We have not observed evidence of significant supplier
spillovers in India. Supplier markets are well developed in India for
mechanical components, such as metals and plastics; however, for higherend components the supplier markets are relatively undeveloped. These
components include TV tubes (where there are few suppliers), integrated
circuits, and printed circuit boards (which are imported).
Distribution of FDI Impact
Companies
FDI companies. International companies have gained market share
through FDI in all segments in India (Exhibit 15). LG and Samsung, in
particular, have done so successfully by providing goods tailored to the
local needs at a significantly lower price, backed by strong advertising
campaigns. Our measurement of company profitability, backed by
interview evidence, suggests that while the Korean companies have been
profitable, other FDI-players have not been as profitable and are far below
what an expected risk-adjusted rate of return might be assumed to be
(Exhibit 16).
Non-FDI companies. Local companies have suffered both from lost
market share and reduced profitability after the entry of international
companies into India. Profitability has declined from 7-8 percent net
margins before the entry of LG and Samsung to near zero following their
entry. Data until 2001 indicate that none of the FDI players were
returning a risk-adjusted cost of capital. Interviews suggest that the
profitability of local companies has continued to decline in 2002
(Exhibit 16).
Employment
Increased competition has reduced employment in the sector, thereby
increasing productivity. There is no data available from which to make a
comparison of wage levels in FDI companies compared to non-FDI
companies.
Consumers
Prices. The consumer has been the clearly gained from FDI in India:
prices have been reduced considerably due to increased competition.
For example, in 2001 alone TVs price dropped 9 percent and washing
machines and air conditioners each dropped 10 percent. LG and
Samsung have been key in driving these prices down as they have
produced goods at significantly lower prices that compete directly with

116

Exhibit 15

MARKET SHARE EVOLUTION BY SEGMENT IN INDIA CONSUMER


ELECTRONICS
Percent
Mobile handsets

FDI company

Computers and its peripherals

1996

1996

2001

N/A

2001

1. Nokia
2. Siemens

47
12

1. HCL Infosystems
2. Wipro

15
15

3. Motorola
4. Panasonic

11
9

3. Zenith Computers
4. CMC

4
1

5. Samsung
6. Sony Ericsson
7. Others

8
6
7

Televisions

5. Rolta India
6. Others

1
63

1. Tech Pacific
Technology (distributor)

14

2. Hewlett Packard
3. Wipro

11
9

4. HCL Infosystems
5. CMC
6. Rolta India
7. Compuage Infocom
8. Zenith Computers
9. Others

8
3
3
3
3
46

Refrigerators

1996

1996

2001

2001

1. Videocon International
2. BPL

25
22

1. Videocon International
2. BPL

23
15

1. Godrej Appliances
2. Whirlpool

44
21

1. Whirlpool
2. Godrej Appliances

32
15

3. Mirc Electronics
4. Philips

11
8

3. LG Electronics
4. Mirc Electronics

10
9

3. Voltas
4. Electrolux Kelvinator

20
1

3. LG Electronics
4. Electrolux Kelvinator

14
13

5. Others

34

5. Samsung India
6. Philips
7. Others

8
3
32

5. Others

15

5. Voltas
6. Others

8
18

Source: Center for Monitoring the Indian Economy; IDC

Exhibit 16

INDIA CONSUMER ELECTRONICS MARKET PROFITABILITY*

FDI company

Percent

Winners
ROIC 1998-2001

LG**

23

HCL Infosystems

20

Industry
focus

Losers
ROIC 1998-2001

Industry
focus

Brown/white

Godrej

-3

White goods

PCs

Amtrex-Hitachi

-2

White goods

-1

White goods

Mirc

12

Brown goods

Electrolux/
Kelvinator

BPL

12

Brown goods

Matsushita

Brown goods

Videocon
Appliances

12

White goods

Whirlpool of India

White goods

Samtel

12

Brown goods

Philips India

Brown goods/
other***

* These are approximate ROIC estimates in some cases as detailed financials for fully accurate estimates not available
** ROIC for 2001 only; analysis of balance sheet indicates that this profit figure may not account for some expenses
allocated to Korea that should be allocated to India
*** About 50% of Philips India sales include non-CE items such as lamps
Source: Company financials; McKinsey Global Institute

117

those of local players (and are well adapted to the local market demand
needs). LG, in particular, is widely cited as driving price reductions in
televisions, having reduced their own prices by nearly 20 percent in one
year, leading other companies in India to respond similarly (Exhibit 17).
Similar price decreases and corresponding increase in volumes can also
be seen in other consumer electronics sub-segments. The growth in
sales volumes resulting from these price reductions indicates a price
elasticity of at least 1-2 for consumer electronics in India (Exhibit 18).
Product variety and quality. The variety of goods has expanded following
FDI in India, with FDI companies bringing newer and more advanced
products, such as flat-screen televisions, to the market.
Government. It is not clear what the impact of FDI is on government tax
receipts in India.
HOW FDI HAS ACHIEVED IMPACT
Operational factors. FDI has improved productivity in two ways. First, is has
ensured the introduction of improved manufacturing techniques. Secondly, it
has invested in greenfield operations that have improved productivity through
the use of efficient production processes. Both these factors are seen in the
Korean entrants.
Industry dynamics. As profitability has decreased with falling prices, FDI and
non-FDI companies have responded by attempting to improve and consolidate
the operations of their plants, trimming headcounts. This is a direct response
to the price reductions arising from Korean FDI.
EXTERNAL FACTORS THAT AFFECTED THE IMPACT OF FDI
The factors that have reduced the impact of FDI in India fall into two categories
those that have reduced the total market size (and have thus lessened its ability
to build scale in India) and those that have reduced export capability. Falling into
the first category are import barriers and indirect taxes, as well as sales tax
regulations. All these lead to higher prices in India. Falling into the later category
is the poor export infrastructure and restrictive labor laws, both of which make
manufacturing in India more expensive than elsewhere. All other things being
equal, a dollar of FDI in India has less impact than in does in China, as in India it
does not create the incremental export opportunities seen in China (and FDI is
often the key to consumer electronics exports).
Country specific factors
Import barriers. These both inflate prices, by increasing the costs of inputs,
and reduce the competitive pressures on final goods. Tariffs in India often
range from 30-50 percent (exhibits 8 and 9).
Indirect taxes. As mentioned earlier, indirect taxes are extremely high in
India; they suppress market demand (Exhibit 10).

118

Exhibit 17

TV PRICE REDUCTION IN 2001 FOR SELECTED INDIA CONSUMER


ELECTRONICS PLAYERS*
Percent
19.2
17.6

13.3
10.5

LG

Toshiba/
Videocon**

Akai/
Videocon**

LG cited for
starting
price war
in televisions

Thomson

* Price reduction in TVs measured as change in price/volume


** Toshiba and Akai brands are produced under license by Videocon International
Source: Literature search

Exhibit 18

PRICE REDUCTION VS. CHANGE IN DEMAND IN INDIA CONSUMER


ELECTRONICS 2001
Price reductions and change in demand, 2001; Percent
Price reduction

Refrigerator

Change in sales

10-12

25

12

Air conditioner

Indicates a
price elasticity
between 1-2*
Television

Washing
machine

15

13

-3

* Assumes a GDP per capita growth of 4% and an income elasticity of 1


Source: CETMA; literature search

119

Sales tax regulations. In addition to adding to the price of final goods, these
regulations reduce productivity by creating a less efficient retail grey market
(illicit, though not technically illegal activities that are not reported to the tax
authorities and the income from which thereby goes untaxed and
unreported). This activity encourages the fragmentation of manufacturing
capacity. The grey market thrives for easily concealable goods such as
mobile handsets, which can be transported easily, thereby avoiding the
differences in sales tax imposed by the various states. Furthermore,
because manufacturers often receive rebates for local manufacturing,
fragmentation of operations is encouraged and the resulting volume per
plant in India is lower than in other countries (Exhibit 19).
Infrastructure. Export processing is slow in India, thus hindering potential
exporters ability to compete with locations such as China (Exhibit 12).
Labor laws. These increase the cost of operating in India. Strong unions
prevent retrenchment, increase costs and decrease productivity vis--vis
China (Exhibit 11).
Informality. Informality plays a particularly strong role in the PC segments,
because the many "garage players" evade taxes. Furthermore, informality in
retail encouraged by high sales taxes makes the retail distribution chain
less productive and potentially more costly.
Initial conditions in the sector
Closing the gap with best practice. Because Indian companies' product
portfolios were not as broad as FDI companies, the increased competition
FDI has brought has improved the product range (e.g., by introducing flatscreen televisions). The initial gap allowed FDI to have a higher impact than
it might otherwise.
SUMMARY OF FDI IMPACT
FDI impact has been positive in India and has greatly benefited consumers as
productivity gains and increased competition have driven prices down. While nonFDI players have lost market share to FDI players, no companies in the industry
(perhaps with the exception of LG and Samsung) appear to be achieving adequate
returns on their cost of capital. FDI's impact on exports has been very small.
Exporters prefer manufacturing in China to doing so in India for several reasons,
including China's large market size (which allows for the building of scale locally
with better developed suppliers), better export infrastructure, and more favorable
labor laws. The Indian government could help advance both the Indian consumer
electronics domestic markets and its export markets by taking steps to decrease
the levels of indirect taxes and improve the country's export infrastructure and
labor laws.

120

Exhibit 19

SALES TAX EXEMPTIONS IMPACT ON MANUFACTURING


FRAGMENTATION
Production per location
Thousand units

LG Manufacturing facilities in India

Contract
CTV
assembly

Owned CTV
assembly

Mohali
Noida

Lucknow

LG India

Guwahati

Sales tax exemptions


for local manufacturers
drives fragmentation
Fragmentation reduces
productivity due to
increased overhead,
capital investment, and
complexity

220

Kolkata

Surat

Contract
CTV
assembly

Average
China*

1,000

Chennai
New CTV
plant

* Average for three large producers that make between 600,000 and 1.7 million TVs per plant
Source: Literature search; McKinsey Global Institute

Exhibit 20

INDIA CONSUMER ELECTRONICS SUMMARY

External
factors
1

FDI enters India due to both a recent opening to FDI, good


growth potential, and because import barriers make FDI
the only way to compete in India; stringent labor laws and
poor export infrastructure deter efficiency-seeking FDI

FDI, especially from Korean companies, begins to drive


additional competition in the market place, reducing prices
and increasing output growth

However, the same tariff barriers that helped attract FDI


decrease competition from imports

Korean players setup higher efficiency operations in India


and improve productivity of operations through best
practice manufacturing techniques; other FDI and non-FDI
companies are forced to follow suit

Furthermore, very high indirect taxes on good combined


with tariffs on inputs directly increase goods prices and
reduce demand

FDI impact has been positive in India and has greatly


benefited consumers as productivity gains and
increased competition have driven prices down.
However, because several external factors suppress
market demand, scale is not built in India and FDIs
potential link to export channels are not realized. Indias
internal market size and export are both small

FDI

Industry
dynamics

5
4
Operational
factors
6

Sector
performance

121

Exhibit 21

INDIA CONSUMER ELECTRONICS FDI OVERVIEW

Total FDI inflow (1996-2001)

$2.4 billion

Annual average
Annual average per sector employee

$0.4 billion
35%
$4,100

Annual average as a share of GDP

0.08%

Annual average as a share of sector value added

Entry motive (percent of total)


Market seeking

100%

Efficiency seeking

0%

Entry mode (percent of total)


Acquisitions

0%

JVs

20%

Greenfield

80%

Exhibit 22

INDIA CONSUMER ELECTRONICS FDI IMPACT


IN HOST COUNTRY
Preliberalization
Economic impact (Pre-1994)

Sector

n/a

PostliberalFDI
ization
(1994-2001) impact
[+]

n/a

Indias output far below what would be expected at

development levels; FDI has helped bring


competition that has started to improve penetration
n/a

employment
(CAGR)

Suppliers

Evidence
FDI still has small market share

(CAGR)

Sector

[]

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

Productivity still low by international standards;

[+]

productivity
(CAGR)

Sector output

++
+

Sector employment at about 15% of Chinas


levels, but may have grown slight with market
growth. Not clear this is attributable to FDI

n/a

Supplier industries in some inputs like television


tubes, not driven by FDI (hypothesis to be tested)

Impact on
competitive
intensity (net
margin CAGR)

n/a

FDI suppliers drive price wars in some segments

122

Exhibit 23

INDIA CONSUMER ELECTRONICS FDI IMPACT


IN HOST COUNTRY (CONTINUED)

Preliberalization
Economic impact (Pre-1994)

++
+

[]

PostliberalFDI
ization
(1994-2001) impact

Highly positive
Positive
Neutral
Negative
Highly negative
Estimate

Evidence

Companies
MNEs

n/a

Domestic
companies

n/a

/+

/+

MNEs profitability very low (except LG who is

Local companies have mixed profitability but

new); gaining share in some segments


/

are losing share to MNCs in some segments


(e.g., white goods)

Employees
Level of
employment
(CAGR)
Wages

n/a

[+]

[+]

Sector employment at about 15% of Chinas

n/a

No evidence on changes in wages

n/a
n/a

+
[+]

levels, but may have grown slight with market


growth. Not clear this is attributable to FDI
]

Consumers
Prices
Selection

+
[+]

Prices falling due to multinational company


presence

FDI has brought some more advanced products


(e.g., flat screen TVs)

Government
Taxes

n/a

No clear impact of FDI on taxes

Exhibit 24
High due to FDI
High not due to FDI

INDIA CONSUMER ELECTRONICS


COMPETITIVE INTENSITY
Prior to
focus period
(pre-1994)
Pressure on
profitability

n/a

New entrants

n/a

Weak player exits

n/a

Pressure on
prices

n/a

Changing market
shares

n/a

Pressure on
product
quality/variety

n/a

Pressure from
upstream/downstream industries

n/a

Overall

n/a

Postliberalization
(1994-2001)

Low
 Back-up page included

Evidence

Industry profitability
moderate and stable
over time period

Several new entrants

Rationale for FDI contribution

Entry of FDI players spurred


on price reductions which
influenced profitability

All new entrants are FDI

in brown and white


goods

No weak player

N/a

exits observed

Price pressure strong in FDI players especially Korean


brown and white goods,
driven by FDI entry
n/a

companies are the strongest


contributors to price reductions

Leading players losing FDI players are biggest


market share in three
gainers
of four markets
Shift from small, black Happens during period where
and white televisions to
more FDI players are entering
larger color televisions

123

Exhibit 25
++ Highly positive

INDIA CONSUMER ELECTRONICS EXTERNAL


FACTORS EFFECT ON FDI
Impact
Impact on
level of FDI Comments
Level of FDI*
Global
Global industry
factors
discontinuity

Global industry restructuring does

Relative position
Sector Market size potential
Prox. to large market
Labor costs
Language/culture/time zone

+
O
O
O

in) Macro factors

not benefit India due to barriers that


deter efficiency seeking FDI
Market still small but room for
growth
Low labor costs but did not draw
efficiency seeking FDI due to other
external factors
Macro factors not as favorable as
China (large deficit, more political
instability)

Country stability
Product market regulations
Import barriers
Preferential export access
Country Recent opening to FDI
specific
Remaining FDI regulation
factors
Government incentives
TRIMs
Corporate Governance
Taxes and other
Capital deficiencies
Labor market deficiencies

on per
$ impact

High trade barriers made entry

++
O
+
O
O
O
O

through trade impossible

FDI liberalization continues to


draw FDI through mid-1990s

High indirect taxes suppress


demand

Labor market does have some

Underdeveloped export

Competitive intensity

+ (M)

Lower competitive intensity drew

Gap to best practice

+(H)

Very high gap to best practice in

( ) Initial conditions

Comments

O
O
O
O
O

O
O
O
O
O
O

Add to high prices, which reduce market size


and decrease scale building for export as in
China; protect weaker companies

High indirect taxes lead to high prices, which


reduce market size and decrease scale building for export as in China. Also sales tax regulations encourage fragmentation of operations
Decreases efficiency and opportunity for FDIdriven exports (which market seekers might
pursue as complement to their strategy)

Decreases efficiency and opportunity for FDI-

infrastructure repel some


efficiency seeking FDI
Sector
initial
conditions

Highly negative

rigidities, which partially account


for lack of efficiency seeking FDI
Informality
Supplier base/infrastructure

Negative

+ Positive
O Neutral

driven exports (which market seekers might


pursue as complement to their strategy)
O (M)

some FDI in the early nineties


+ (H)

Allows for more productivity growth per $ FDI

products and productivity

Exhibit 26

INDIA CONSUMER ELECTRONICS


FDI IMPACT SUMMARY

[ ] Estimate

++ Highly positive
+ Positive
O Neutral

( ) Initial conditions
External Factor impact on

FDI impact on host country


Level of FDI relative to sector*

35%

Economic impact

Sector productivity
Sector output

Level of FDI** relative to GDP

[+]
+
[O]

Suppliers

[O]

Impact on
competitive intensity

Level of FDI

Global factors

Sector employment

Countryspecific factors

Companies
FDI

+/

Non-FDI

O/

Employees
Wages

0.08

Global industry
discontinuity

Relative position
Sector market size potential
Prox. to large market
Labor costs
Language/culture/time zone

+
O
O
O

O
O
O
O

Macro factors
Country stability

Product market regulations


Import barriers
Preferential export access
Recent opening to FDI
Remaining FDI restriction
Government incentives
TRIMs
Corporate governance
Taxes and other

++
O
+
O
O
O
O

O
O
O
O
O
O

Capital deficiencies

Labor market deficiencies

Informality

Supplier base/
infrastructure

[+]
[O]

Consumers
Prices

Selection

[+]

Government
Taxes

Per $ impact
of FDI

Distributional impact

Level

Negative
Highly negative

[O]

* Average annual FDI/sector value added


** Average (sector FDI inflow/total GDP) in key era analyzed

Sector initial
conditions

Competitive intensity

+ (M)

O (M)

Gap to best practice

+ (H)

+ (H)

Preface to the Food Retail


Sector Cases
The food retail sectors in Brazil and Mexico are similar in market size and average
income level. Both received significant FDI in the second half of 1990s (Exhibit 1).
This preface provides the background information necessary for a full
understanding of the comparative cases.
BACKGROUND AND DEFINITIONS
FDI typology. All FDI in food retail has been market-seeking; the motive for
international companies to enter the Brazilian and Mexican markets has been to
grow by gaining market share in the local markets. Among all the sectors studied
here, the local nature of consumer food preferences and the need for a local food
product supplier base makes food retail the sector where success most depends
on local market knowledge.
Global food retail market trends. Large retailers in developed economies have
seen their domestic markets mature. In the mid-1990s, many of these leading
global players expanded rapidly into foreign markets (Exhibit 2). Three players,
Ahold, Carrefour, and Wal-Mart led this trend, and two of the three (Carrefour and
Wal-Mart) are present in both Brazil and Mexico. While these two companies have
different approaches to global expansion, their entry methods and subsequent
performance illustrate the role that local market conditions play in shaping the
strategy and outcome, as evident in such areas as the entry options and
acquisition opportunities that are available to them (Exhibit 3).
Sector segmentation. We have used two sets of variables to segment the food
retail market: modern versus traditional formats and formal versus informal
businesses (Exhibit 4).
Modern versus traditional distinction refers to the store format of each
retailer. Modern formats (e.g., hypermarkets, supermarkets, discount stores,
and mini-markets) refer to self-service formats in which a customer can select
his or her own merchandise. Traditional formats (e.g., counter stores, street
vendors, street markets) refer to non-self-service formats in which a customer
requires an employee to help customer select his or her merchandise.
Formal versus informal distinction refers to the level of tax compliance.
Formal retailers comply with tax and legal obligations (e.g., Valued Added tax,
social security, health standards) while informal retailers do not.
The cases of Brazil and Mexico illustrate that there is no set relationship between
the two segmentations. The dominant retailers in Brazil are modern informal
retailers (i.e., modern self-service retailers that do not fully comply with fiscal
requirements) that gain a significant advantage over their formal competitors from
the savings gained from underreporting sales (thus avoiding the high levels of
Value Added taxes on foodstuffs) and from underreporting salaries (avoiding
significant employee-related taxes and required benefits). In Mexico, in contrast,
most food is exempt from Value Added tax and, as a result, there are no
significant modern informal players. In fact, while informality is the rule among
small-scale traditional players, many traditional retailers in urban areas choose to
register and comply with fiscal requirements.

Exhibit 1

COMPARISON OF LEVEL OF DEVELOPMENT AND RETAIL FDI FLOWS IN


BRAZIL VS. MEXICO
Brazil and Mexico have similar
per capita income and food
consumption . . .

. . . and both received similar amounts


of FDI in retail

GNP per capita (PPP)

Average annual FDI flow in retail


sector as share of sector value
added*
Percent

Food consumption
per capita (PPP)
Share of food
consumption in GNP (%)

6,460

Brazil

17

Brazil

4.2

14

Mexico

1,096
7,450

Mexico

2.4

1,062

* Average FDI from 1996-2001 as share of 2001 food retail value added
Source: Government sources

Exhibit 2

INTERNATIONAL EXPANSION BY TOP GLOBAL FOOD RETAILERS


2001-02

Number of new countries entered


1981-85

1986-90

Source: Annual reports

21

20

19

15

-1

1996-2000

1991-95

13

Most
international
expansion took
place in the
second half
of the 1990s

Exhibit 3

ENTRY METHODS FOR INTERNATIONAL EXPANSION


Greenfield

JV/Acquisition

Japan
Developed

Canada
U.K.
Germany

Developing

Mexico
China
Brazil*

Developed

Developing

Switzerland
Greece**
Belgium**

Mexico
Colombia
China
Romania

U.S.
Denmark
Norway
Portugal

Spain
Sweden

Slovakia

Peru

Thailand

Costa Rica
El Salvador

Slovakia Dominican
Republic
Thailand
Argentina

Developed

Czech

Malaysia
Republic Morocco

Latvia
Lithuania

Developing

Most international expansion


through JV or acquisition

Portugal South Korea


Singapore Spain
Japan
Italy
Brazil
Poland
Chile
Czech
Republic

Required JV entry

Tunisia Mauritius
Turkey
Malaysia
Taiwan

Guatemala
Paraguay
Argentina
Brazil

Chile
Indonesia
Nicaragua
Estonia

Most international expansion


through greenfield entry. Some
entry into developing markets
through JV and into developed
market through acquisition of
Promodes in 1999

Typically pursued a
JV/acquisition strategy for new
international market entry

* Greenfield stores with initial financial partner


** Entered through acquisition of Promodes
Source: Company reports

Exhibit 4

INFORMALITY IN FOOD RETAIL IN BRAZIL AND MEXICO


Characteristics of the business activity

Full reporting of all


business revenues
and employment

Food retail:
Modern

Exists in Brazil
and Mexico

Registered as a
business entity but
partial reporting of
business revenues
and employment

Not registered as a
business entity

Food retail:
Significant in
Brazil but not in
Mexico

Type of
companies

Food retail:
Exists in Mexico
Traditional

MGI definition of
informality

Key threat to more


productive formal retailers in
Brazil since reap significant
advantages from being
informal
Not common in Mexico since
unable to beat more
productive large formal
players due to small benefits
of informality

Food retail:
Significant in
Mexico but not
Brazil

Traditional players in Mexico


deliver on convenience, but
likely lack capital to grow
Convenient modern retailers
in Brazil limit the growth of
the traditional sector

In Mexico, tax burden on


food retail is low and many
traditional retailers in urban
areas choose to register and
avoid audit risks
Source: Interviews; McKinsey

Employment in the traditional sector. In developing countries, employment in


the traditional food retail sector tends to be more sensitive to general
macroeconomic conditions than most other sectors. In the absence of
unemployment benefits, joining an existing family business or selling food
products on the streets are two of the few options open to workers who lose their
jobs elsewhere. This should be kept in mind when interpreting changes in
employment in the traditional segment.
SOURCES
Data. Productivity, output, and employment estimates were based on data from
both industry association sources that provided in-depth information on the
leading modern players, as well as government statistical sources (household and
employment surveys and, in Mexico, the commercial census). We have used this
data to incorporate the traditional sector and informal players in our estimates.